LIFO question question

Elliotbay

A major benefit of LIFO inventory costing method is that it lowers income taxes.

However, along with assumption in rising prices - are we also assuming that the selling price will remain constant (gross profit margin will decrease in this case). If not, then if we were to increase the selling price in equivalent to match the gross profit margin, the income tax would exactly be the same as if one were to use FIFO or avg costing.

Can someone please validate the above assumption.

Let me know if this is not clear and I will provide an example.

Thanks.

dece2011

Yes, agreed that the emphasis is on inflationary COGS during LIFO in comparison to FIFO. However, there should be a caveat that selling prices should be constant in each period in order to achieve income tax cost savings for the LIFO period.

A simple example: let's say there are 2 widgets

Cost
widget A- $5
widget B: $7

Selling Price
All widgets- $10

-----------------
FIFO EBT: $5
LIFO EBT: $3

Lower income earned during LIFO hence less taxes paid.

Now, let's say the upward pressure on costs have driven the firm to raise prices to keep 50% gross margin (during LIFO), so instead of the constant selling price we have:

Selling Price
widget A- $10
widget B- $14

which translates to the following EBT:

FIFO EBT: $5
LIFO EBT: $7

Higher income earned during LIFO hence higher taxes paid.

Conclusion: Inflationary COGS during LIFO does lower income taxes given the selling price is either constant or decreasing.

Is there a flaw in my analysis.

joemoran

MLAMOTHE Wrote:
-------------------------------------------------------
> Correct me if I'm wrong, but it doesn't matter if
> the selling price of the final product increases
> or decreases. The question at hand is whether
> LIFO decreases income taxes COMPARED to FIFO in a
> COGS inflationary environment. Therefore, no
> matter whether the final product selling price is
> going up, down, or staying the same, as long as it
> is standardized between FIFO and LIFO, LIFO will
> always create lower income taxes in a COGS
> inflationary environment. Correct?

Correct. The idea is to compare LIFO vs FIFO for ANY given Sales price.

Micholien

With LIFO with assumption in rising prices, though you are increasing the price of a product you also need to assume the SG& A costs increasing along with the inflation.

End of the day in when the prices are increasing LIFO will have higher COGS and so less taxes.

manasib

Correct me if I'm wrong, but it doesn't matter if the selling price of the final product increases or decreases. The question at hand is whether LIFO decreases income taxes COMPARED to FIFO in a COGS inflationary environment. Therefore, no matter whether the final product selling price is going up, down, or staying the same, as long as it is standardized between FIFO and LIFO, LIFO will always create lower income taxes in a COGS inflationary environment. Correct?

cyber21

Thanks guys.

jimmykaw, in your example you have provided Feb income, which in fact has opposite effect (higher taxes) because the LIFO includes the earlier cheaper inventory.

Here is an example I was thinking of:

Cost/widget
Month 1 - $40
Month 2 - $50
Month 3 - $60

Price/widget
Month 3 - $80
Month 4 - $80

Let's say 2 widgets were sold

Under FIFO
$80 - $40 = $40
$80 - $50 = $30
Total Inc = $70

Under LIFO
$80 - $60 = $20
$80 - $50 = $30
Total Inc = $50

Under LIFO, COGS are higher therefore low income - thus, lower taxes.

However, for the the same example let's change gross margin:

Cost/widget
Month 1 - $40
Month 2 - $50
Month 3 - $60

Price/widget
Month 3 - $80
Month 4 - $100

Let's say 2 widgets were sold

Under FIFO
$80 - $40 = $40
$100 - $50 = $50
Total Inc = $90

Under LIFO
$80 - $60 = $20
$100 - $50 = $50
Total Inc = $70

So, the conclusion is that the LIFO reserve is exactly the same whether the profit margin is constant or increasing (assuming the cost is increasing) and that not all inventory is taken into account, i.e. assume some inventory is tied up into asset.

Does this make sense at all?

Any accountants in the house?

jim8z3

jimmykaw Wrote:
-------------------------------------------------------
> Here is an example where the selling prices are
> increasing at the same rate as cost prices.
>
> Cost Prices-
> nov 08: 40
> dec 08: 50
>
> Selling Prices-
> Jan 09: 80
> Feb 09: 100
>
> FIFO-
> Jan Income: 80-40=40
> Feb Income: 100-50=50
>
> LIFO-
> Jan Income: 80-50=30
> Feb Income: 100-40=60
>
> So LIFO will always lead to lower taxes in rising
> prices.


Great illustration! Thanks!

__________

"good personality ... or he was known as Lt. Mandingo during his army days."

burnsy562000

I think you all dead right on it, but let us not leave on important factor out here. The rising prices of products (inputs) are accompanied with increasing purchase quantities for LIFO to produce higher COGS, Lower income and consequently low taxes.

RobertA

Just to be clear here...we are saying LIFO will lead to lower taxes initially, in the long run the taxes could be same, depending on the rate of change of selling prices. In the above example, taxes will be lower in Jan but in Jan and Feb combined they will be same.

thisisbrianly

Here is an example where the selling prices are increasing at the same rate as cost prices.

Cost Prices-
nov 08: 40
dec 08: 50

Selling Prices-
Jan 09: 80
Feb 09: 100

FIFO-
Jan Income: 80-40=40
Feb Income: 100-50=50

LIFO-
Jan Income: 80-50=30
Feb Income: 100-40=60

So LIFO will always lead to lower taxes in rising prices.