To understand how different stock valuation methods affect profitability, let’s explore detailed examples using FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and the Average Cost Method. These examples will demonstrate how the cost of goods sold (COGS) and net profits are impacted under each method.
1. Scenario Overview
A company made the following purchases and sales during the month of January:
Purchases:
- January 1: Purchased 100 units at $10 each = $1,000
- January 10: Purchased 150 units at $12 each = $1,800
- January 20: Purchased 200 units at $14 each = $2,800
Sales:
- January 25: Sold 300 units at $20 each = $6,000
The objective is to calculate the cost of goods sold (COGS), ending inventory, and gross profit using different stock valuation methods.
2. Using FIFO (First-In, First-Out)
FIFO assumes that the oldest inventory is sold first. Therefore, the COGS will be calculated using the costs from the earliest purchases.
Step 1: Calculate Cost of Goods Sold (COGS)
- First 100 units from January 1 at $10 = $1,000
- Next 150 units from January 10 at $12 = $1,800
- Final 50 units from January 20 at $14 = $700
Total COGS (FIFO) = $1,000 + $1,800 + $700 = $3,500
Step 2: Calculate Ending Inventory
- Remaining 150 units from January 20 at $14 = $2,100
Ending Inventory (FIFO) = $2,100
Step 3: Calculate Gross Profit
- Sales Revenue = 300 units × $20 = $6,000
- Gross Profit = $6,000 – $3,500 = $2,500
3. Using LIFO (Last-In, First-Out)
LIFO assumes that the most recently purchased inventory is sold first. Therefore, the COGS will be calculated using the costs from the latest purchases.
Step 1: Calculate Cost of Goods Sold (COGS)
- First 200 units from January 20 at $14 = $2,800
- Next 100 units from January 10 at $12 = $1,200
Total COGS (LIFO) = $2,800 + $1,200 = $4,000
Step 2: Calculate Ending Inventory
- Remaining 50 units from January 10 at $12 = $600
- Remaining 100 units from January 1 at $10 = $1,000
Ending Inventory (LIFO) = $600 + $1,000 = $1,600
Step 3: Calculate Gross Profit
- Sales Revenue = 300 units × $20 = $6,000
- Gross Profit = $6,000 – $4,000 = $2,000
4. Using the Average Cost Method
The Average Cost Method assigns a uniform cost per unit based on the average price of all units available for sale.
Step 1: Calculate Total Units and Total Cost
- Total Units Purchased = 100 + 150 + 200 = 450 units
- Total Cost = $1,000 + $1,800 + $2,800 = $5,600
Step 2: Calculate Average Cost per Unit
- Average Cost per Unit = $5,600 ÷ 450 units = $12.44 per unit
Step 3: Calculate Cost of Goods Sold (COGS)
- COGS = 300 units × $12.44 = $3,732
Step 4: Calculate Ending Inventory
- Ending Inventory = 150 units × $12.44 = $1,866
Step 5: Calculate Gross Profit
- Sales Revenue = 300 units × $20 = $6,000
- Gross Profit = $6,000 – $3,732 = $2,268
5. Summary of Results
| Method | COGS | Ending Inventory | Gross Profit |
|---|---|---|---|
| FIFO | $3,500 | $2,100 | $2,500 |
| LIFO | $4,000 | $1,600 | $2,000 |
| Average Cost | $3,732 | $1,866 | $2,268 |
6. Analysis of Results
A. Profitability Impact
- FIFO: Produces the highest gross profit ($2,500) in periods of rising prices because older, cheaper inventory is sold first.
- LIFO: Results in the lowest gross profit ($2,000) as it accounts for the most recent, more expensive inventory.
- Average Cost: Provides a middle-ground gross profit ($2,268), smoothing out price fluctuations.
B. Ending Inventory Impact
- FIFO: Results in higher ending inventory values, reflecting more recent, higher-priced inventory.
- LIFO: Results in lower ending inventory values, reflecting older, cheaper stock.
- Average Cost: Provides a balanced valuation of ending inventory.
The Effect of Stock Valuation on Profitability
These examples illustrate how different stock valuation methods impact a company’s cost of goods sold, gross profit, and ending inventory. FIFO leads to higher profits during inflationary periods, while LIFO can reduce taxable income by increasing COGS. The Average Cost Method offers a balanced approach, minimizing the effects of price fluctuations. Choosing the right valuation method depends on a company’s financial strategy, market conditions, and regulatory requirements.