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

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

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

Answer: (A)

When prices are falling, the latest costs are the lowest. Using those lower costs to value the cost of goods sold reduces COGS, which raises the profit on the sale. For example, imagine three units on hand with costs 10, 9, and 8. If you sell two units at a price of 12 each, the profits under different methods look like this: - LIFO (latest costs first): COGS = 8 + 9 = 17; profit = 24 − 17 = 7. - FIFO (oldest costs first): COGS = 10 + 9 = 19; profit = 24 − 19 = 5. - Average cost: average cost is 9, so COGS = 18; profit = 24 − 18 = 6. - Specific identification could vary depending on which specific items are sold, but the lowest COGS (and thus the highest profit) in this deflationary scenario comes from using the latest, lowest costs. Thus, in a falling-price environment, the inventory method that uses the most recent costs for COGS tends to produce the highest profits.

When prices are falling, the latest costs are the lowest. Using those lower costs to value the cost of goods sold reduces COGS, which raises the profit on the sale.

For example, imagine three units on hand with costs 10, 9, and 8. If you sell two units at a price of 12 each, the profits under different methods look like this:

• LIFO (latest costs first): COGS = 8 + 9 = 17; profit = 24 − 17 = 7.

• FIFO (oldest costs first): COGS = 10 + 9 = 19; profit = 24 − 19 = 5.

• Average cost: average cost is 9, so COGS = 18; profit = 24 − 18 = 6.

• Specific identification could vary depending on which specific items are sold, but the lowest COGS (and thus the highest profit) in this deflationary scenario comes from using the latest, lowest costs.

Thus, in a falling-price environment, the inventory method that uses the most recent costs for COGS tends to produce the highest profits.