Why You Should Switch to Lifo

TO: Raphaela Gonzalez, wholesale produce

FROM: David Lyon, Accounting Student

DATE: June 13, 2012

SUBJECT: Why you should switch to LIFO

Dear MRS. Gonzalez,

Although I know you strive to maintain a FIFO flow of goods, as your adviser I suggest that you start using a LIFO flow of goods for this reason. Once we get this system going I promise you will see a dramatic increase in your cash flow.

First, I know you are thinking that if we adopt a LIFO flow of goods that most of your goods will perish before they can be sold. This is simply not the case, because you are having issues with inflation by implementing LIFO the rising price of your produce will be reported as cost of goods sold rather than accumulating in your inventory. For example on June 1st, you bought 10 vine ripened tomatoes for $3 a vine and sold for $6 a vine. On June 3rd, a customer bought 6 of those tomatoes. On June 15th, you bought 20 vine ripened tomatoes from the same supplier at $4.75 a vine and sold for $6. Then on June 16th, another customer bought 5 tomatoes. With FIFO this means that the tomatoes you bought on June 1 at the lowest price will be the ones to sell first giving you a cost of goods sold at $34.75 [(10@3)+(1@4.75)] with sales at $66 giving you a gross profit of $31.25 and an inventory of $90.25. With LIFO you can still sell the ones you bought first but report them with the inflated price. Using the same example the June 15th purchase with the highest price will be the one "to sell first" giving you a cost of goods sold of $52.25 [11@4.75] with sales at $66 giving you a gross profit of $13.75 and an inventory of $72.75 [(9@4.75)+(10@3)]which more accurately records what is

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happening. Although using the LIFO sounds like you are receiving less income this will be made up for the less amount you will have to pay for in taxes which I will later describe.

Secondly I advise that you switch to a perpetual inventory system rather than a periodical, this will be a little more work intensive for awhile until we get all your inventory accounted for. By implementing a perpetual inventory system this will give you more of a real time assessment of your inventory. Meaning that you will be able to react to trends in sales of certain produce by ordering more or less. This will also enhance the effect that I am going for by using the LIFO assumption flow of your inventory.

Last, lets finish with the taxes. Because with FIFO artificially raising your net income by assigning the lowest cost of goods sold this means with a higher net income you have to pay more taxes. By using LIFO which assigns the highest to cost of goods sold that also better matches current costs with revenues when calculating gross profit.

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