Which inventory valuation method provides higher profits when prices are rising?

Which inventory valuation method provides higher profits when prices are rising?

• A. AVCO
• B. Specific identification
• C. FIFO
• D. LIFO

Answer: (C)

When prices are rising, using the oldest costs for cost of goods sold tends to boost reported profits. This is what happens with the method that assigns the earliest, lower costs to COGS: the cost of goods sold is lower, while the ending inventory reflects the newer, higher costs. Lower COGS means higher gross profit, which then increases net profit compared with other methods. If you used newer costs for COGS, profits would be lower because COGS would be higher. Averaging costs smooths the effect, giving profits that fall between the extremes. Specific identification can vary depending on which particular items are sold, so its impact is less predictable.

When prices are rising, using the oldest costs for cost of goods sold tends to boost reported profits. This is what happens with the method that assigns the earliest, lower costs to COGS: the cost of goods sold is lower, while the ending inventory reflects the newer, higher costs. Lower COGS means higher gross profit, which then increases net profit compared with other methods.

If you used newer costs for COGS, profits would be lower because COGS would be higher. Averaging costs smooths the effect, giving profits that fall between the extremes. Specific identification can vary depending on which particular items are sold, so its impact is less predictable.