Inflation relation to Inventory Accounting

Suppose you set-up a tea stall. You decide to keep a profit of 40% on the tea you sell. You tend to purchase and keep inventory of the following:

1. Tea ( Rs.40)
2. Sugar (Rs.20)
3. Ginger (Rs.20)
4. Cardamom (Rs. 20)

You tend to refill the inventory every week and at any given time you have 2 weeks of inventory with you. Milk is purchased on a daily basis and its price is largely constant. The per week expenditure on Milk is Rs. 100.

One following week when you go to make the inventory purchase you realize the cost of all the four (except Milk) have increased by 20% each. Following week you sit out to calculate the profit earned for the week. You are worried to know the impact on increased prices on your profit margin since he had decided not to raise tea prices correspondingly.

If you had been using FIFO:

Cost of Goods Sold = Rs. 100 ( 4 products - old inventory) + Rs 100 ( Milk) = Rs. 200

Profit = Rs. 200 * 1.4 = Rs. 280


If you had been using LIFO:

Cost of Goods Sold = Rs. 120 ( 4 products - old inventory) + Rs 100 ( Milk) = Rs. 220

Profit = Rs. 220 * X = Rs. 280 therefore X = 27.27%

The above example goes to show when cost of inventory goes up, the profit margin calculated by LIFO goes down substantially vis-avis FIFO.