The first-in, first-out (FIFO) inventory cost method can be used to minimize taxes during periods of rising prices, since the higher inventory prices work to increase a company’s cost of goods sold (COGS), decrease its earnings before interest, taxes, depreciation and amortization (EBITDA), and therefore reduce the amount of earnings used to calculate the amount of taxes owed.
With the FIFO method, the newest inventory goods purchased that will be used in a sale are used first. In periods of rising prices, this means that the older, less expensive inventory remains on the company’s books in the form of inventory assets on the balance sheet. The newer, more expensive inventory is used in the sale of its goods or services and is removed from its balance sheet and recognized on its income statement in the form of COGS.
Since revenue minus COGS equals gross profit, using the FIFO inventory cost method in periods of rising prices reduces gross profit, which then reduces all other profit levels and the amount of taxes owed. This also reduces net profit.
In periods of declining prices, however, using the FIFO inventory cost method would actually increase the amount of taxes owed. Since prices would be declining in this scenario, the inventory used in the sale of a company’s product would be lower than the inventory kept on its books, and therefore the gross profit would be higher. This would work to increase all other profit levels and the amount of taxes owed. This would also increase overall net profit.