Inventory Costing Choice Under Rising Prices
Marlow Outfitters began the year with 100 units at $20 each. During the year it purchased 200 units at $24 and 200 units at $28, then sold 350 units at a $50 selling price. Prices rose steadily all year. The company currently uses FIFO. Management is considering switching to LIFO to reduce income taxes, but the bank loan covenant requires a current ratio of at least 1.5, and inventory is the largest current asset. The controller notes that ending inventory under FIFO will be higher than under LIFO. The tax rate is 25%. Management wants to know the trade-offs before deciding.
1. Compute cost of goods sold and ending inventory under both FIFO and LIFO, and determine the tax savings from using LIFO.
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Units available: 100 + 200 + 200 = 500. Units sold: 350. Ending inventory: 150 units.
FIFO (oldest costs leave first): COGS = 100×$20 + 200×$24 + 50×$28 = $2,000 + $4,800 + $1,400 = $7,600 Ending inventory = 150×$28 = $4,200
LIFO (newest costs leave first): COGS = 200×$28 + 150×$24 = $5,600 + $3,600 = $9,200 Ending inventory = 50×$24 + 100×$20 = $1,200 + $2,000 = $3,200
Tax effect: LIFO COGS exceeds FIFO COGS by $9,200 − $7,600 = $1,600. Higher expense lowers pretax income by $1,600, so tax savings = $1,600 × 25% = $400.
In rising prices, LIFO raises COGS, lowers taxable income, and lowers ending inventory - exactly the trade-off management faces.
2. How does the FIFO-to-LIFO choice affect the current ratio and the loan covenant, and what should management weigh?
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Effect on current ratio: LIFO produces a lower ending inventory ($3,200 vs. $4,200, a $1,000 difference). Since inventory is the largest current asset, switching to LIFO reduces current assets and therefore lowers the current ratio, pushing the company closer to (or below) the 1.5 covenant threshold. FIFO keeps inventory and the current ratio higher.
Trade-offs management must weigh:
- LIFO: saves $400 in taxes now and better matches current costs to current revenue, but lowers reported inventory, net income, and the current ratio - risking a covenant violation that could trigger loan acceleration.
- FIFO: higher inventory, higher current ratio (protects the covenant), and higher reported income, but a higher tax bill.
The decision is not purely tax-driven: the covenant constraint may outweigh the $400 tax saving. Management should also confirm the tax rules permit the method and consider consistency (a change requires disclosure and justification). The judgment call is balancing tax minimization against liquidity-covenant compliance.