Question

Explain the difference between LIFO and FIFO and document the method used for each of the three companies(Coca Cola,Pepsi and Dr Pepper).

Answer 1

Answer:

FIFO stands for First In First Out and is an inventory costing method where goods placed first in an inventory are sold first. Recently-placed goods that are unsold remain in the inventory at the end of the year.

LIFO stands for Last In First Out. It is an inventory costing method where the goods placed last in an inventory are sold first. The goods placed first in the inventory remain in the inventory at the end of the year.

Comparison
	FIFO	LIFO
Stands for	First in, first out	Last in, first out
Unsold inventory	Unsold inventory comprises goods acquired most recently.	Unsold inventory comprises the earliest acquired goods.
Restrictions	There are no GAAP or IFRS restrictions for using FIFO; both allow this accounting method to be used.	IFRS does not allow using LIFO for accounting.
Effect of Inflation	If costs are increasing, the items acquired first were cheaper. This decreases the cost of goods sold (COGS) under FIFO and increases profit. The income tax is larger. Value of unsold inventory is also higher.	If costs are increasing, then recently acquired items are more expensive. This increases the cost of goods sold (COGS) under LIFO and decreases the net profit. The income tax is smaller. Value of unsold inventory is lower.
Effect of Deflation	Converse to the inflation scenario, accounting profit (and therefore tax) is lower using FIFO in a deflationary period. Value of unsold inventory, is lower.	Using LIFO for a deflationary period results in both accounting profit and value of unsold inventory being higher.
Record keeping	Since oldest items are sold first, the number of records to be maintained decreases.	Since newest items are sold first, the oldest items may remain in the inventory for many years. This increases the number of records to be maintained.
Fluctuations	Only the newest items remain in the inventory and the cost is more recent. Hence, there is no unusual increase or decrease in cost of goods sold.	Goods from number of years ago may remain in the inventory. Selling them may result in reporting unusual increase or decrease in cost of goods.

Example:

Suppose a business that trades in widgets makes the following purchases during the year:

• Batch 1: Quantity 2,000 pieces at $4 per piece
• Batch 2: Quantity 1,500 widgets at $5 a piece
• Batch 3: Quantity 1,700 widgets at $6 per piece

This means a total of 5,200 widgets were purchased. Of these, let's assume the company managed to sell 3,000 units at a price of $7 each. Now the remaining inventory of 2,200 widgets needs to be valued. What should be the unit cost used to determine the value of this unsold inventory? This is the question that LIFO and FIFO methods attempt to answer.

Using FIFO

Using the FIFO method of accounting, the unsold inventory is those goods that were acquired most recently. This means that all 1,700 widgets in Batch 3 and 500 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (1,700 * $6) + (500 * $5) = $12,700.

The accounting profit for the company in this scenario using FIFO is calculated as follows:

• Revenue: 3,000 * $7 = $21,000
• Cost of goods sold: Batch 1 (2,000 * $4) + Batch 2 (1,000 * $5) = $13,000
• Profit: $21,000 - $13,000 = $8,000

It should be noted that this is strictly an accounting concept. It's quite possible that the widgets actually sold during the year happened to be from Batch 3. But as long as they are the same, standardized widgets, Batch 3 goods are unsold for the purposes of accounting.

Using LIFO

Using the LIFO method for accounting will give us different results. The value of the unsold inventory will be different because the earliest acquired goods are considered unsold in LIFO. This means all 2,000 widgets from Batch 1 and 200 of the 1,500 widgets in Batch 2 are considered unsold. So the value of the unsold inventory is (2,000 * $4) + (200 * $5) = $9,000.

The accounting profit using LIFO is calculated as follows:

• Revenue: 3,000 * $7 = $21,000
• Cost of goods sold: Batch 2 (1,300 * $5) + Batch 3 (1,700 * $6) = $16,700
• Profit: $21,000 - $16,700 = $4,300

A company in the same business can either use similar or different inventory costs. Coca-Cola and Pepsi is an example of companies who are in the same industry but differ in their inventory cost. Coca-Cola uses the First In First Out (FIFO) inventory costing method, which assumes that goods first purchased are going to be sold first. Pepsi, on the other hand, uses both First In First Out (FIFO) and Last In First Out ( LIFO), which means that some goods can be purchased first and sold first, or they can be last to purchased and first to be sold.

Coca Cola’s inventories include raw materials as well as finished products. The raw

Materials include ingredients, supplies and packaging. The finished products are mostly syrups and concentrates sold to bottlers and fountain retailers. In certain areas, Coca Cola also bottles the syrups or concentrates before selling them. PepsiCo’s inventories not only include drink-related ones, but also ones related with snacks and cereals. As a result, they also include ingredients such as wheat, rice and potatoes.

The figures for cost of goods sold for Coca Cola are as follows:

(in Millions)	2007	2008	2009
COGS	$10,406	$11,374	$11,088

The breakdown of cost of inventories for Coca Cola is as follows:

(in Millions)	2007	2008	2009
Raw Materials and Packaging	$1,199	$1,191	$1,366
Finished Goods	$789	$706	$697
Other	$232	$290	$291
Total Inventories	$2,220	$2,187	$2,354

      Coca Cola uses the average cost and FIFO method in determining cost of inventories. In addition, as with other firms, they also value them at lower of cost or market. PepsiCo uses the average cost, FIFO and LIFO methods. In PepsiCo’s case, approximately 10% in 2009 and 11% in 2008 of inventories were valued using the LIFO method.

      We now compare inventory’s growth, inventory turnover ratio and average days to turnover over three years. We will take a look at these figures for Coca Cola, PepsiCo and the Dr Pepper Snapple Group.

Coca Cola (Big increase in ending inventory from 2006 to 2007 is explained by increase in sales revenue.)

(in Millions)	2006	2007	2008	2009
Sales Revenue		$28,857	$31,994	$30,990
Ending Inventory	$1,641	$2,220	$2,187	$2,354
Inventory Growth		35.3%	(1.5%)	7.6%
Inventory Turnover Ratio		2.70	2.58	2.44
Average Days to Turnover		135	141	149

PepsiCo
(in Millions)	2006	2007	2008	2009
Sales Revenue		$39,474	$43,251	$43,232
Cost of Goods Sold		$18,038	$20,351	$20,099
Ending Inventory	$1,926	$2,290	$2,522	$2,618
Growth		18.9%	10.1%	3.8%
Inventory Turnover Ratio		8.56	8.46	7.82
Average Days to Turnover		43	43	47

DrPepperSnapple	(Taken public in 2007)
(in Millions)	2007	2008	2009
Sales Revenue	$5,695	$ 5,710	$ 5,531
Cost of Goods Sold	$2,564	$2,590	$2,234
Ending Inventory	$325	$263	$262
Growth		-19.1%	-0.4%
Inventory Turnover Ratio		8.81	8.51
Average Days to Turnover		41	43

Total Asset Turnover Ratio for industry in 2009 is 5.25.

      In absolute terms, Coca Cola’s inventory fluctuated widely while PepsiCo’s was on an upward trend at a decreasing rate. This suggests that Coca Cola did not manage its inventory efficiently as it may have overstocked in 2007, thereby leading to the drop in ending inventory in 2008.

      The inventory turnover ratios for both Coca Cola and PepsiCo have been decreasing over the past three years. This could be a reflection that both companies wrongly forecasted demand for its products to increase more than it has so far.

The inventory turnover ratio for Coca Cola is much lower than for PepsiCo. One reason for this is that PepsiCo sells snacks in addition to beverages. Compared to beverages, the finished snack product and its raw ingredients tend to have a much shorter shelf life. Thus, in order to avoid wastage, PepsiCo has to turn over the inventory much faster than Coca Cola. Another reason may lie in the roughly equal values of inventory for Coca Cola over the past three years. When Coca Cola increased its inventory significantly in 2006, it may have made investments to expand its storage capacity. There would no additional holding costs or storage costs to keep amounts of inventory constantly higher. In addition, as beverages and their raw materials have long shelf-lives, the executives might reason that since commodity prices can fluctuate widely in the global economy, they should stock more inventories at the appropriate times when the prices are lower and prepare for any sudden fluctuations in demand.

Coca Cola’s inventory turnover ratio is lower than the industry average because it is exclusively producing and selling beverages. The industry average will take into consideration firms that like PepsiCo, manufacture products other than drinks.