Let's assume you own the XYZ grocery store and you've decided to start selling cookies. You purchased a case of cookies last week for $25 and a case of cookies this week for $30. Which cookies do you sell first? Under the LIFO method, you would assume you sell the freshest cookies first (regardless of which cookie actually gets sold first).
To see the accounting effects, let's further assume you sell one case of cookies a month. Under the LIFO method, your cost of goods sold for the month would be:
Gross Cookie Sales: $100
Cost of Goods Sold: $30
Gross Margin: $70
Gross Cookie Sales $100
Cost of Goods Sold: $25
Gross Margin $75
As you can see, a company's choice of inventory method has a significant impact on how profitable it appears, especially if a large portion of its assets are tied up in inventory. The choice of inventory method also affects the amount of assets reported on a company's balance sheet and in turn affects many key debt, working capital, turnover, and other ratios. For this reason, it is important for investors to know what inventory method a company uses so they can effectively compare companies.