Question

Assuming constant inventory quantities, which of the following inventory-costing methods will produce a lower inventory turnover ratio in an inflationary economy?A.FIFO (first in, first out).B.LIFO (last in, first out).C.Moving average.D.Weighted average.

Answer 1

Answer:

A) FIFO (first in, first out)

Explanation:

When an economy is said to be inflationary, it means that the general level or prices in the economy is rising quickly.

When the inflation rate is high, a company should not use the FIFO method, since it will overstate its profit and understate its COGS. They might even end up selling below cost without noticing it.

For example, if the company bought 100 units at $10 per unit during January, and it plans to sell them with a 20% markup. But since the inflation rte is very high, for instance 15%, the next time the company buys the same units the price will have increased a lot. If they bought 50 units during July, they will probably pay around $11 per unit. When the company sells the units at $12, instead of making a 20% gross profit, they will be making a gross profit of only around 10-13%. Imagine if the inflation rate was 50% instead of 15%, the situation would be much worse.

When the inflation rate is high, you should always use the LIFO method. When companies use the FIFO method in a high inflationary economy, they will not be willing to sell many units, since their profit is reduced or even negative, this will end up lowering their inventory turnover.