I’m going over the Analysis of Inventories reading in Schweser and I’m having some difficulty understanding something, though I’m sure it’s not extremely important. While discussing the differences between LIFO and FIFO, Schweser appends this bit to the end of the section addressing the differences in activity ratios: “LIFO firms tend to carry larger quantities of inventory than comparable FIFO firms. This can most likely be explained by the tax advantages (i.e., lower taxes due to higher COGS) of LIFO.” I understand the concept of LIFO reducing tax outflows, but I don’t see how this explains why LIFO firms tend to carry larger quantities of inventory. From my understanding, inventory quantities tend to be kept as low as possible across all accounting methods solely because larger quantities lead to larger costs of storage regardless of the cost associated with any particular quantity. Thanks for the help.
I will try to explain as my understand point, if any misunderstand you and others can substitute for more clearance. The explain based on the assumption of rising price period example. The inventory levels and purchased price of your company as following: Beg Inv: 0 items 1st Mar 2008: 1 items @ 2 usd per unit 5th Mar 2008: 2 items @ 3 usd per unit, sales 1 items @ 7 usd per unit 10th Mar 2008: 4 items @ 4 usd per unit, sales 1 items @ 7 usd per unit 12th Mar 2008: 4 items @ 4 usd per unit, sales 2 items @ 8 usd per unit 13th Mar 2008: 5 items @ 5 usd per unit, sales 2 items @ 9 usd per unit If your ending inv quantity is stopped at the date 12th Mar, then end inv quantity will be equal to (1+2+4+4) - (1+1+2+2) = 5 items. COGS dated 5thMar = 1*3=3 COGS dated 10thMar = 1*4=4 COGS dated 12thMar=2*4=8 COGS dated 13thMar=2*4=8 (the input of 12thMar) Total COGS = 3+4+8+8=23 Turnover = 7*1+7*1+8*2+9*2=48 Then EBIT = 48-23=25 If your ending inv quantity is stopped at the date 13th Mar, the ending inventory quantity will be equal to (1+2+4+4+5) - (1+1+2+2) = 10 items. Plus COGS dated 13thMar=2*5= 10 Total COGS = 3+4+8+10=25 Turnover = 7*1+7*1+8*2+9*2=48 Then EBIT = 48-25=23 So, you can easily see that with ending inventory quantity of 5 items the EBIT will be 25. With the ending inventory quantity of 10 items the EBIT will be 23. So, during the rising price period, the more inventory firm keeps the less income tax they have to pay. That is all i understand.
LIFO firms carry larger inventory quantities because they continually have to purchase more quantities than they sell to avoid a LIFO liquidation. A LIFO liquidation occurs when older inventories get transferred to COGS. During periods of rising prices, older inventories can carry a much smaller cost. Current sales prices with older, lower cost, inventory transferred to COGS creates an artificially high gross margin which inflates taxable income.