Inventory Methods That Result in the Lowest Taxable Income in a Period of Decline
Inventory is one of the largest costs for non-service-oriented businesses. It is defined as those assets on the balance sheet that are intended to be sold or used in the current year. In general, inventory can be calculated by adding the value of inventory at the beginning of the accounting period to the value of inventory purchased and then subtracting the cost of goods or product sold in that same period. While the calculation of inventory is rather straightforward, several methods are used to value inventory, which can greatly affect the income statement and subsequently the amount a business pays in income taxes.
If prices were stagnant, you wouldn't need to value inventory, but that's not the case. Due to inflation, prices tend to rise, but they can also decline due to changes in gas prices, drought, flooding and myriad other events that can cause the cost of basic goods sold across multiple industries to fluctuate. Depending on the inventory methodology used, this can change the value of inventory written off on the income statement, which can increase or decrease net income.
The first-in, first-out, or FIFO, method is just as the name implies. It assumes the first inventory to come into a business is the first inventory to be sold. In a period of declining prices, if you purchase 500 ears of corn at $2 each and then purchase 500 additional ears of corn two weeks later at $1 each, the FIFO method of inventory valuation says the cost of good sold should be the ears of corn purchased first, at $2 each. If you sell 500 ears of corn, the cost of that corn is $2 each or $1,000. The cost of the corn still held in inventory -- and recorded on the balance sheet -- is $1 each, or $500.
The last-in, first-out, or LIFO, method is the opposite of FIFO. It assumes that the last inventory purchased is the first inventory sold. In periods of declining prices, this means the lower-priced inventory will be sold first and the higher-priced inventory will be sold last. Using the example above, if you sell 500 ears of corn, the cost of goods sold is $1 per ear, or $500, and the cost of inventory on the books is $2 per ear, or $1,000.
The average cost method is an average of LIFO and FIFO. It takes the weighted average of all units available for sale and applies that value to the cost of goods sold and ending inventory. For example, the average cost of an ear of corn would be [(500 x $2) + (500 x $1)]/1000, or $1.50. The cost of goods sold under the average cost method is $1.50 * 500, or $750.
In periods of price decline, the best method for a lower net income, and therefore lower income taxes, is the method that renders the highest value for the cost of goods sold. As our example shows, FIFO renders a value of $1,000 for cost of goods sold, and LIFO renders a value of $500. The average cost method renders a value that falls midway between both at $750. In periods of price decline, the best methods for a lower net income are FIFO or average cost. Both produce a lower net income and, therefore, a lower income tax.