In an economy with rising costs, the inventory costing method you choose can impact your financial reporting. The FIFO (First In, First Out) method assumes that the oldest inventory – the first products that were purchased or manufactured – are sold first.
Since we're considering an economy with rising costs, the cost of purchasing or producing goods tends to increase over time. Under the FIFO method, the cost of goods sold (COGS) reflects the cost of the oldest inventory, which was acquired at the lowest price because of the rising costs over time.
Therefore, when using the FIFO method, the earliest and typically cheaper inventory gets used first, which results in the lowest COGS when compared to selling the newer, more expensive inventory.
Here's the impact on gross profit calculation:
- Gross profit is calculated as Net Sales minus the Cost of Goods Sold (COGS).
- With a lower COGS (because of using the oldest, cheaper inventory in rising costs environment), the deducted expense from sales will be smaller.
- This leads to a higher remaining amount, which is the gross profit.
In light of these points, if we assume net sales are constant, the FIFO method, by attributing lower costs to COGS, maximizes the gross profit in an economy with rising costs when compared to other inventory costing methods that would use the more recent (and in this case, more expensive) inventory first.
Hence, the correct choice in terms of the impact of FIFO on gross profit in an economy with rising costs is:
C. the highest gross profit.
