What factors should Precision consider in choosing between the FIFO and average cost formulas?
(((ANSWER)))The sales and the operating expense are the same under both FIFO and average. But the cost of goods sold amounts are different. For this case, the price is rising, so it will have a higher profit than using average. This happens because the expenses matched against revenues are the lower unit costs of the first units purchased. Then, the ending inventory will be higher. So in the balance sheet, the asset will be higher. And the current ratio will be higher. If prices are falling, the results from the use of FIFO and average are reversed. FIFO will report the lower profit and average the higher. If prices are stable, both cost formulas will report the same results.
IS DIS CORRECT ADN IF ANY MISTAKE CAN U EDIT PLZ.THANKS
Is English your first language?
If it is, have you slowly read this answer aloud?
english is my seccond language.
OK.
The sales and the operating expenseS are the same under both FIFO and THE AVERAGE COST FORMULAS. But the costS of goods sold amounts are different. For this case, the price is rising, so it will have a higher profit than using THE average. This happens because the expenses matched against revenues are the lower unit costs of the first units purchased. Then, the ending inventory will be higher. So in the balance sheet, the assetS will be higher, AND the current ratio will be higher. If prices are falling, the results from the use of FIFO and average are reversed. FIFO will report the lower profit and average the higher. If prices are stable, both cost formulas will report the same results.
thanks ms.Sue ^_^
You're welcome, Thara. :-)
Your explanation is mostly correct, but there are a few things I would like to clarify and correct:
When choosing between the FIFO (First-In, First-Out) and average cost formulas, Precision should consider several factors:
1. Cost Flow Assumption: FIFO assumes that the oldest inventory is sold first, while average cost assumes that the cost of each unit is the average of all units in inventory. Precision needs to decide which cost flow assumption best reflects the company's operations and inventory management.
2. Revenue Matching: Both FIFO and average cost methods will have the same sales and operating expenses. The key difference lies in the cost of goods sold (COGS). Under FIFO, the COGS will reflect the lower unit costs of the first units purchased, resulting in potentially higher profits. Average cost, on the other hand, spreads the total cost evenly across all units, resulting in potentially lower profits.
3. Inventory Valuation: The ending inventory value will differ between FIFO and average cost methods. FIFO values the inventory at the current cost, as the older, cheaper inventory remains unsold. Average cost, however, uses a blended cost for inventory valuation. This means that if prices are rising, FIFO will result in higher ending inventory and higher asset values on the balance sheet. On the other hand, average cost will result in a lower ending inventory value.
4. Financial Ratios: The choice of cost formula also impacts various financial ratios. For example, if prices are rising, using FIFO will lead to a higher current ratio (current assets divided by current liabilities) due to the increased inventory value. Average cost, on the other hand, may result in a lower current ratio.
In summary, the choice between FIFO and average cost depends on factors such as cost flow assumption, revenue matching, inventory valuation, and the impact on financial ratios. Precision needs to carefully evaluate these factors to determine which method best aligns with its objectives and financial reporting requirements.