The difference between FIFO and LIFO results from the order in which changing unit costs are removed from inventory and become the cost of goods sold. When the unit costs have increased, LIFO will result in a larger cost of goods sold and a smaller ending inventory compared with FIFO. If the unit costs are stable, there will be little or no difference between FIFO and LIFO. Also note that the order in which the costs are removed from inventory is independent of the order in which the physical units are removed from inventory.

To illustrate the difference between FIFO and LIFO, let's assume that a retail store carried only one product during its first year of business. It purchased 30 units in January at a cost of $40 each, 30 units in June at $43 each, and 30 units in November at $46 each. Thus, for the year the retailer purchased 90 units with a total actual cost of $3,870 [30X$40 + 30X$43 + 30X$46]. Let's also assume that 70 units were sold and that 20 units remain in inventory at the end of the year.

FIFO assumes that the first costs (the oldest costs) for 70 of the units will be removed from inventory and will be expensed on the income statement as the cost of goods sold. Hence, the FIFO cost flow assumption is that the 70 units sold had a cost of $2,950 [30X$40 + 30X$43 + 10X$46]. FIFO also assumes that the 20 units remaining in inventory had the most recent cost of $46 each for a total of $920.

LIFO assumes that the last costs (the most recent actual costs) for 70 units will be removed from inventory and will be expensed on the income statement as the cost of goods sold regardless of which units were actually shipped to customers. Therefore, the LIFO cost flow assumption is that the 70 units sold had a cost of $3,070 [30X$46 + 30X$43 + 10X$40]. LIFO also assumes that the 20 units remaining in inventory had the oldest cost of $40 each for a total of $800.

In our example, LIFO results in $120 less of ending inventory and $120 less of gross profit (because the cost of goods sold was larger). The lower gross profit and the associated lower taxable income for a U.S. company can mean less income tax payments if the company is profitable and has significant and increasing levels of inventory.

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