LIFO FIFO

What hath cost wrought?
By Paul Herbig

Today the spot price per barrel of oil reached $40. Natural gas has surpassed $10 mcf and in some markets the spot price has exceeded $27. However, the gas that I buy today at an already extrabortant nearly $2 per gallon has been in process for a long time. First it had to be pumped from the ground. Let’s say that was in Saudi Arabia, Kuwait, Qatar, or in another part of the MidEastern oil protectorate. It then has to be transported by pipeline to storage vats until it can be offloaded onto the giant oil tankers that traverse the seas. By the time the oil is loaded, anywhere from 1 to 3 weeks or more has passed. Those huge tankers are not built for speed but for capacity. At 10 knots it must travel seven to ten thousand miles before it reaches the American shores. The trip is easily a month. By the time the oil is offloaded to an American storage tank, it is perhaps 6 weeks removed from the ground. It will stay in those tanks for an indefinite period of time. But oil is worthless to the average American. It has to be refined to the much more desirable gasoline. Another week or two perhaps before it has become a useful product. Then it is once again moved by pipeline to its regional destination, stored again, and then finally moved by tank truck to your near-by Texaco, Shell, Marathon (or more likely Murphy Walmart or Meijer or BP) to enable you to fillup your prized vehicle and allow you to get from home to work back to home again.

Three months has passed. That gas you bought today was brought up from the ground ninety days ago. Yet the price of gas escalates and varies from day to day. The cost was known ninety days ago so the price should be predictable today. Ninety days ago a barrel of oil cost $25 and gas was $1.50. Why should the price of a gallon of gas that was pumped out of the ground 3 months ago vary according to the current price of a barrel of oil that won’t become gas for another three months?

The answer comes from FIFO and LIFO. No, these are not the names of the dogs of the royal family of Saudi Arabia. These are accounting terms and their derivation has made the phenomenon described above so commonplace. Forty years ago, FIFO (First in, first out) was the traditional way of determining costs. In this system, cost was determined by when the product was produced (in our example above, cost for oil being consumed as gasoline today would be estimated based on its original cost when pumped—the $25 per barrel of three months ago). This system was widely used and accepted when inflation was minimal. Then came the inflation of the seventies and especially the stagflation of the 1979-80. Goods were being sold for less than their original cost and companies were taking accounting baths.

LIFO to the rescue. By making a simple accounting change, companies were turned around. Instead of costing items to the original, the cost of the last item produced (last in) was compared to the current unit being sold (first out . . . get it LIFO). Now that $40 per barrel oil being pumped today did not have to wait for three months to be expensed at $40 but could be paired with gas being sold today. Voila, $25 per barrel oil now cost $40 and prices could be adjusted daily in accordance with the current (spot . . . whatever the price was at this moment) price of oil. And that, my fine friends, explains why only the today’s costs matters and the past is irrelevant.

An owner was hiring a new accountant and invited three for an interview. He asked the first what “2+2 equals?” Sensing a trap, the first accountant pulled out his calculator and through logaritimic functions, integration, linear algebra, and differential equations calculated the answer at 3.999956 plus or minus .000005. The second accountant was asked the same question. He stared at the owner and said, “What a silly question, four of course.” When the third accountant was asked, he got up silently, closed the door, pulled the curtains on the windows, used his bug meter to check for any hidden bugs in the room, turned the radio up as high as it would go, asked the owner to sign a confidentiality agreement and said “What do you want it to be?” Guess who got the job.

Marketing may make the world go around but it is those accountants who do the final tally of profits.