Question

During periods of rising costs, which inventory costing method produces the highest gross profit?

Short answer

The average cost is computed after making every purchase.

Step-by-step solution

Different inventory costing methods

There are four inventory costing methods namely –

1) Specific identification cost

2) First in First out (FIFO)

3) Last in First out (LIFO)

4) And the Weighted average cost

In specific identification, the specific cost is used for each inventory issue. Under the first in first out method, the cost of inventory introduced first into the stocks is used first. The last in first out method values the inventory based on the latest inventory cost. The average costing method is based on calculating the average cost after each purchase.

Inventory costing during rising prices.

During rising prices, the current cost of inventory is highest as compared to the earlier price. Thus, the inventory valued on the current cost would be the highest. The highest cost of inventory would fetch the lower gross profit. There would be the same opposite effect if the inventories are valued at the earliest price and not at the current price.

Under the FIFO method, the inventories are valued at the earliest price. So the cost of goods sold would be lowest and the gross profit would be highest as compared to any other method.