Page 9 - tmp

LIFO

The "Last In, First Out" method of inventory entails using current prices to count a
measure called "the cost of goods sold," as opposed to using what was paid for the
inventory already in stock. If the price of such goods has increased since the initial
purchase, the "cost of goods sold" measure will be higher and thereby reduce profits and
tax burdens. Nonperishable commodities like petroleum, metals and chemicals are
frequently subject to LIFO accounting.

"LIFO isn't a good indicator of ending inventory value, because the leftover inventory
might be extremely old and, perhaps, obsolete," Melwani said. "This results in a valuation
much lower than today's prices. LIFO results in lower net income because cost of goods
sold is higher. So [there is a] lower taxable income. By using more recent inventory in
valuation, your cost basis is higher on current income statements. This reduces gross
profit and ultimately net income. This is the implication of LIFO, and many companies
prefer LIFO because lower profit reporting means a reduced tax burden."

As an example of how LIFO works, a website development company might purchase a
plugin for $30 and then sell the finished product at $50. However, several months later,
that asset is increased in price to $35. When the company then writes off profits, it would
use the most recent price of $35 as part of LIFO. In tax statements, it would then appear
as if the company made a profit of only $15. By using LIFO, a company would appear to
be making less money than it actually did, and therefore have to report less in taxes.

The principle of LIFO is highly dependent on how the price of goods fluctuates based on
the economy. If a company holds inventory for a long period of time, holding on to product
may prove quite advantageous in hedging profits for taxes. LIFO allows for higher after-
tax earnings due to the higher cost of goods. At the same time, these companies risk the
cost of goods going down in the event of an economic downturn and causing the opposite
effect for all previously purchased inventory.

FIFO and LIFO similarities

FIFO and LIFO are quite different inventory management techniques. However, they are
similar in one regard: They both depend on the product remaining the same, with price
being the only fluctuating element.

FIFO and LIFO influence a company's earnings on paper. FIFO is most successful when
used in an industry when the price of a product remains steady and the company sells its
oldest products first. That's because FIFO is based on the cost of the first goods
purchased, ignoring any increases or reductions in price for newer units. LIFO, in
comparison, works well in an industry when prices fluctuate, and the newest units are
sold first.

7