What is the difference between FIFO and LIFO, and what is the effect of each on net income during periods of inflation?

FIFO (First-In, First-Out) assumes oldest inventory sold first, while LIFO (Last-In, First-Out) assumes newest inventory sold first. During inflation, FIFO results in lower COGS and higher net income, while LIFO results in higher COGS and lower net income.

FIFO vs LIFO During Inflation

During periods of inflation (rising prices), FIFO and LIFO have opposite effects on financial statements, particularly on Cost of Goods Sold (COGS) and Net Income.

FIFO (First-In, First-Out) Effect:

COGS: Based on older, lower costs → Lower COGS
Ending Inventory: Valued at newer, higher costs → Higher Inventory Value
Gross Profit: Revenue - Lower COGS = Higher Gross Profit
Net Income: Higher Net Income (before and after tax)
Tax Expense: Higher due to higher pre-tax income

LIFO (Last-In, First-Out) Effect:

COGS: Based on newer, higher costs → Higher COGS
Ending Inventory: Valued at older, lower costs → Lower Inventory Value
Gross Profit: Revenue - Higher COGS = Lower Gross Profit
Net Income: Lower Net Income (before and after tax)
Tax Expense: Lower due to lower pre-tax income

Comparison Table:

Financial Item	FIFO (Inflation)	LIFO (Inflation)
Cost of Goods Sold	Lower	Higher
Ending Inventory	Higher	Lower
Gross Profit	Higher	Lower
Pre-tax Income	Higher	Lower
Income Taxes	Higher	Lower
Net Income	Higher	Lower
Working Capital	Higher	Lower
Current Ratio	Higher	Lower

Practical Example and Implications

Numerical Example:

Scenario: Company buys and sells identical products. Prices rising throughout year:

Jan 1: Buy 100 units @ $10 = $1,000
Jun 1: Buy 100 units @ $12 = $1,200
Dec 1: Buy 100 units @ $15 = $1,500
Total purchases: 300 units, Total cost: $3,700
Sell 250 units @ $20 each = $5,000 revenue
Ending inventory: 50 units

FIFO Calculation:

COGS: 100 @ $10 + 100 @ $12 + 50 @ $15 = $1,000 + $1,200 + $750 = $2,950
Ending Inventory: 50 @ $15 = $750
Gross Profit: $5,000 - $2,950 = $2,050

LIFO Calculation:

COGS: 100 @ $15 + 100 @ $12 + 50 @ $10 = $1,500 + $1,200 + $500 = $3,200
Ending Inventory: 50 @ $10 = $500
Gross Profit: $5,000 - $3,200 = $1,800

Key Insights:

FIFO shows $250 higher gross profit than LIFO
LIFO inventory value is $250 lower than FIFO
Tax savings with LIFO if tax rate is 25%: $250 × 25% = $62.50
FIFO shows "better" profit but pays more tax
LIFO shows "worse" profit but saves tax cash