The FIFO (First-In, First-Out) method of inventory valuation assumes that the oldest inventory costs are used up first when calculating the cost of goods sold (COGS). When prices are rising, the older inventory costs tend to be lower than the current prices. Consequently, the COGS calculated under FIFO will reflect these lower costs.
This results in a higher gross profit because the lower COGS reduces the expense against revenue. Since gross profit contributes directly to net income, a higher gross profit thus leads to a higher net income under the FIFO method during periods of rising prices. As a direct consequence, companies using FIFO in an inflationary environment will report increased net income compared to those using methods like LIFO (Last-In, First-Out), which would reflect higher COGS and therefore lower net income.
This understanding of how inventory valuation methods affect financial metrics is crucial, particularly in cost management and financial reporting.