National Evaluation Series (NES) Business Studies Practice Test

If a small business uses the LIFO inventory costing method and its primary raw material price increases, what is a likely outcome?

1. Gross profit will likely increase

2. Cost of inputs will rise, reducing gross profit

3. Net income will remain unchanged

4. Operating costs will decrease

The correct answer is: Cost of inputs will rise, reducing gross profit

When a small business employs the LIFO (Last In, First Out) inventory costing method, it records the most recently acquired inventory as sold first. This means that during periods of rising prices for raw materials, the cost of goods sold (COGS) reflects the higher costs of the most recent inventory purchases. As a result, the COGS increases, which leads to a lower gross profit since gross profit is calculated as sales revenue minus COGS. In this scenario, as the price of the primary raw material rises, the reported cost of inputs also rises because the business is accounting for the more expensive inventory first. Since gross profit is significantly influenced by the COGS, an increase in COGS due to higher input costs will ultimately reduce the gross profit margin. Thus, the business is likely to experience a decrease in profitability as a direct result of these rising material costs. This understanding highlights the dynamic nature of inventory costing methods and their implications on financial statements, particularly in contexts of fluctuating prices.