Which inventory valuation method is likely to yield higher profits during periods of inflation?

The first-in, first-out (FIFO) method of inventory valuation is likely to yield higher profits during periods of inflation because it assumes that the oldest inventory items (which were purchased at lower prices) are sold first. As inflation causes prices to rise, the newer inventory, which costs more, remains on the balance sheet longer.

As a result, when FIFO is used, the cost of goods sold (COGS) is lower because it reflects the lower costs associated with the older inventory. This leads to a higher gross profit and net income on the income statement. Furthermore, since net income affects key financial ratios, using FIFO can also positively impact the perceived profitability of the company during inflationary periods.

In contrast, the LIFO (last-in, first-out) method would yield lower profits during inflation, as it accounts for the most recent, typically higher-priced inventory as the cost of goods sold. The average cost method smooths out price fluctuations over time, resulting in moderate profit levels, while specific identification tracks individual items but is less commonly used for large inventory systems. Thus, FIFO is generally the most favorable method in an inflationary environment.