How does inventory method (FIFO vs LIFO) affect COGS, taxes, and cash flow in a model?

• A. Inventory method has no tax impact
• B. Different methods shift COGS and ending inventory, affecting gross margin and taxes; LIFO can reduce taxes in inflationary periods but may lower reported profits; impacts cash flow via tax and working capital.
• C. FIFO always reduces taxes
• D. LIFO increases cash flow in all cases

Answer: (B)

The key idea is that the inventory cost flow method changes where costs appear in the financial statements, which in turn shifts gross margin, taxable income, and cash flow. In inflationary periods, using LIFO means the most recent, higher costs are matched against current revenue, so COGS is higher and gross profit and pre-tax income are lower. This lowers tax expense and can improve after-tax cash flow in the near term. Ending inventory under LIFO consists of older, cheaper costs, so it tends to be lower on the balance sheet, affecting current assets and working capital. With FIFO, COGS uses older, lower costs, so COGS is smaller, gross margin and pretax income are higher, taxes are higher, and cash outflow for taxes is increased, while ending inventory is higher and boosts working capital. Over time, these timing differences create tax deferral opportunities under LIFO in rising-price environments, but they can also reduce reported profits and alter balance-sheet metrics. In short, the method shifts where costs sit, which changes margins, tax expense, and cash flow through taxes and working capital needs.