Comparison of Cost Flow Assumptions

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.

The examples assumed that costs were continually increasing. The results would be different if costs were decreasing or increasing at a slower rate. Consult with your tax adviser concerning the election of a cost flow assumption.

In past periods of inflation, many U.S. companies switched from FIFO to LIFO. However, once the switch is made, a company cannot change back to FIFO.

Specific Identification

In addition to the six cost flow options discussed earlier, businesses have another option: expense to the cost of goods sold the specific cost of the specific item it decided to sell. For example, Gold Dealer, Inc. has an inventory of gold and each gold bar has an identification number with the cost of the gold bar. When Gold Dealer sells a gold bar, it can expense to the cost of goods sold the exact cost of the specific gold bar sold. The cost of the other gold bars will remain in inventory. (Alternatively, Gold Dealer could use one of the other six cost flow options described earlier.)

LIFO Benefits Without Tracking Units

Earlier we demonstrated that during periods of increasing costs, LIFO resulted in less profits. In the U.S. this can mean less income taxes paid by a corporation. Most corporations view lower taxes as a significant benefit. However, the process of tracking costs and then assigning those costs to the units sold and the units on hand could be too troublesome for the amount of income tax savings. To gain the benefit of LIFO without tracking costs, there is a method known as dollar value LIFO. This topic is discussed in intermediate accounting textbooks. The Internal Revenue Service also allows companies to use dollar value LIFO by applying price indexes. (You should seek the advice of an accounting and/or tax professional to assess the cost and benefit of LIFO techniques.)

Inventory Management

Over the past decades sophisticated companies have made great strides in reducing their levels of inventory. Rather than carry large inventories, they ask their suppliers to deliver goods “just in time.” Suppliers and merchandisers have learned to coordinate their purchases and sales so that orders and shipments occur automatically.

A company will realize significant benefits if it can keep its inventory levels down without losing sales or production (if the company is a manufacturer). In its early days, Dell Computers greatly reduced its inventory in relationship to its sales. Since the cost of computer components had been dropping as new technologies emerged, it benefited Dell to keep a small inventory of components on hand. It would be a financial hardship if Dell had a large quantity of components that became obsolete or decreased in value.

Financial Ratios

Keeping track of inventory is important. There are two common financial ratios for monitoring inventory levels: (1) Inventory Turnover Ratio, and (2) Days’ Sales in Inventory. These are discussed and illustrated in the Explanation of Financial Ratios.