In periods of rising prices, which inventory costing method produces a lower gross margin, lower income before tax, and smaller cash outflows for income tax purposes?

• A. FIFO method
• B. Weighted Average
• C. Specific Identification
• D. LIFO method

Answer: (D)

In inflationary periods, the cost flow that pushes the newest, higher costs into cost of goods sold first has the strongest effect on reducing margins and taxes. This is LIFO. By selling the most recently acquired inventory, cost of goods sold increases because those costs are higher due to rising prices. That higher COGS cuts into revenue to reduce gross margin, and it also lowers pretax income. When pretax income is lower, the amount of income tax owed is lower, so cash outflows for taxes shrink. The flip side is that ending inventory tends to be valued lower, reflecting older, cheaper costs.

Other methods behave differently in this scenario: FIFO uses older, cheaper costs for costs of goods sold, boosting gross margin and pretax income and leading to higher taxes. Weighted average falls somewhere in between, and specific identification depends on which items are actually sold.