Final answer:
Using the FIFO method during periods when supplier prices are falling can result in a lower net profit in the short term, as the inventory costs recorded are based on older, higher-priced stock.
Step-by-step explanation:
When considering the effect on net profit using the FIFO (First-In, First-Out) inventory assignment method during periods of falling supplier prices, we can analyze the impact on a business with an example. Let's take a messenger company where gasoline is a significant cost. As the prices for gasoline decrease, the cost of delivering packages drops. This decrease in costs would typically lead to higher profits because the company can deliver services at a lower cost without necessarily lowering the prices charged to customers. With FIFO, the cost of goods sold reflects the cost of the oldest inventory, which in a falling price environment would be higher than the most recently purchased inventory. Therefore, using FIFO, the net profit will be slightly lower during this period than if the company were using LIFO (Last-In, First-Out), because the cost of goods sold recorded on the income statement would be based on the earlier, higher-priced inventory.
This situation would not change the economic reality that the company is indeed incurring lower costs presently, which over time can lead to increased profits. However, for accounting purposes, FIFO causes expenses to appear higher in the short term when prices are falling, and hence net income is reported as lower during that specific period.
Yet, if the firm keeps its prices stable while costs fall, it may decide to expand its service area or increase its supply, because the lower costs correspond to a potential for higher profits. These strategic moves could lead to a shift in the supply curve to the right, indicating a larger quantity supplied at any given price. Over time, as the older, more expensive inventory is depleted, the cost of goods sold will begin to reflect the lower purchase costs and the net profit will improve.