CFA CFA Level 1 LIFO Reserve

LIFO Reserve

  • This topic has 2 replies, 2 voices, and was last updated Jan-21 by pcunniff.
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    • pcunniff
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      Hey everyone! Can someone help with this? A little lost on the explanation when it says that operating margin would be higher because of the older and lower costs being included. Wouldnt Inventory costs be higher as well?

      In an inflationary environment, a LIFO liquidation will most likely result in an increase in:

      A)inventory.

      B)accounts payable.

      C)operating profit margin.

      Explanation

      In a LIFO liquidation, older and lower costs are included in cost of sales. Thus, cost of sales per unit decreases and profit margins increase. (LOS 25.e)

    • rahul12
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      hey @pcunniff this is a CFA L1 favorite which most candidates need some time to grasp the logic of the concept (and once you do you’ll remember it).

      let’s start with a few definitions to make sure we are on the same page:

      1) LIFO liquidation occurs when the amount of goods sold exceed the amount of goods replaced, i.e. number of inventory units is decreasing. don’t get distracted by the word LIFO in this phrase at this stage, the definition merely means that we are running low in inventory (regardless of FIFO/LIFO classification).

      2) so, in a LIFO liquidation situation during an inflationary environment, the older (and lower) cost of goods are included into COGS, because we are selling the ‘older’ lower cost units in our inventory now.

      3) therefore COGS reduces on average, and profit margins increases.

      sorry, it sounds like I repeated the answer. inventory cost is not higher because in an inflationary environment AND LIFO liquidation (based on the definitions above), you’re selling the older, cheaper stock which brings down average COGS and increases profit.

      answer A is incorrect because LIFO liquidation by definition means inventory levels are decreasing.

      I hope this helps a little, let me know if not and will see if i can better explain

    • pcunniff
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      roger that @rahul12

      I think your point 2 above helped clear things!

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