MCQ Quiz

<h3>First Principles Thinking: How cost layers flow</h3><p><strong>B is correct.</strong> COGS reflects the cost assigned to the units a firm is assumed to have sold. Under LIFO in an inflationary environment, the newest purchases have the highest cost. These high-cost units are pulled into COGS immediately. This pushes expense recognition upward, reducing gross profit. The PDF's Company L (LIFO) example shows systematically higher COGS compared with FIFO because each year's purchases rise by 4%. Memory hook: <em>“LIFO loads income with the Latest costs.”</em></p><p>A is incorrect because FIFO sends older, cheaper layers to COGS, lowering expense and raising profit in inflation. New, more expensive units remain in inventory.</p><p>C is incorrect because the weighted-average method softens cost movements—it cannot exceed LIFO in inflation unless price spikes are irregular, which is not the case in the PDF’s steady 4% inflation scenario.</p>

<h3>First Principles Thinking: Timing of cost recognition</h3><p><strong>A is correct.</strong> FIFO expends the oldest inventory costs first. In inflation, those older costs are cheaper than current ones. By keeping expensive layers in ending inventory, FIFO defers inflationary cost recognition and reports a lower COGS figure. Because profit = sales − COGS, lower COGS yields higher income. As shown in the PDF's Company F (FIFO) example, income and gross margins exceed those of Company L (LIFO) when prices rise. Memory hook: <em>“FIFO floats profits upward in inflation.”</em></p><p>B is incorrect because FIFO delays the recognition of newer, higher costs.</p><p>C is incorrect because income is affected by <em>timing</em> of COGS recognition, even though the total pool of cost is identical across methods.</p>

<h3>First Principles Thinking: Reverse the price ladder</h3><p><strong>A is correct.</strong> In deflation, earlier purchases are more expensive. FIFO sends these older, higher-cost layers to COGS first, raising COGS relative to LIFO. LIFO uses newer, cheaper layers, lowering COGS. Thus the ranking in inflation reverses under deflation. Memory hook: <em>“Flip inflation to deflation, flip FIFO vs. LIFO.”</em></p><p>B is incorrect because LIFO uses the newest (here cheapest) layers first, not the expensive ones.</p><p>C is incorrect because cost-flow assumptions still matter even if total cost pools are identical. Deflation does not erase method differences.</p>

<h3>First Principles Thinking: Turnover = COGS ÷ Ending Inventory</h3><p><strong>A is correct.</strong> Turnover rises when COGS increases relative to ending inventory. Under LIFO with inflation, COGS is high (new expensive layers), while ending inventory is valued at old, low historical costs. This gives a large numerator and small denominator, producing a higher turnover ratio. The PDF's tables confirm this pattern across all five years. Memory hook: <em>“LIFO: High COGS, Low Inventory = Fast Turnover.”</em></p><p>B is incorrect because FIFO increases ending inventory values, lowering turnover—not raising it.</p><p>C is incorrect because both companies sell identical physical quantities; only valuation differs.</p>

<h3>First Principles Thinking: Raiding cheap layers</h3><p><strong>A is correct.</strong> LIFO liquidation occurs when a firm sells more units than it purchases. Once recent layers are exhausted, the firm must expense older layers that were acquired at lower costs. This reduces COGS and artificially inflates gross profit. The PDF emphasizes this rising-profit effect when older layers are released. Memory hook: <em>“LIFO liquidation = unlocking cheap costs.”</em></p><p>B is incorrect because expensive recent layers are already gone—the liquidation triggers <em>cheaper</em> layers flowing into COGS.</p><p>C is incorrect because liquidation directly changes COGS composition, thus altering gross profit.</p>

<h3>First Principles Thinking: Matching current cost with current price</h3><p><strong>A is correct.</strong> LIFO assigns current, inflation-adjusted costs to COGS. Selling prices also rise each year. When cost and price grow at the same rate, the gross margin ratio (price minus cost divided by price) remains stable. The PDF’s Company L shows flat margins for this reason. Memory hook: <em>“LIFO margin = price and cost climbing together.”</em></p><p>B is incorrect because LIFO expends newer, not older, layers.</p><p>C is incorrect because LIFO does not average costs; it prioritizes the most recent units for COGS.</p>

<h3>First Principles Thinking: Reverse the cost gradient</h3><p><strong>A is correct.</strong> Under deflation, recent purchases are cheaper. LIFO expends these low-cost recent purchases, which reduces COGS and raises gross margin. FIFO expends older, higher-cost layers first, depressing gross margin. Memory hook: <em>“In deflation, LIFO lifts margins.”</em></p><p>B is incorrect because FIFO keeps the cheapest layers in inventory, not in COGS.</p><p>C is incorrect because deflation directly changes which cost layers flow through COGS, affecting margins.</p>

<h3>First Principles Thinking: Which layer stays on the shelf?</h3><p><strong>A is correct.</strong> Replacement cost is the cost the company would pay today to restock inventory. Under FIFO, ending inventory reflects the newest purchases—precisely the units acquired at current, higher inflation-adjusted prices. In the PDF, Company F consistently reports higher ending inventory values because its inventory is valued at current prices. This best approximates economic replacement value. Memory hook: <em>“FIFO ending inventory = what's on the shelf now.”</em></p><p>B is incorrect because LIFO leaves the oldest historical layers in inventory, which do not reflect current prices at all, especially during sustained inflation.</p><p>C is incorrect because weighted-average smooths costs backward in time; its inventory value lags true replacement cost unless inflation is minimal.</p>

<h3>First Principles Thinking: LIFO base layers are frozen</h3><p><strong>A is correct.</strong> LIFO assumes the latest units are sold first. As long as purchases each year equal or exceed sales, older units are never relieved from inventory. They remain on the balance sheet at their original acquisition cost. The PDF explicitly shows Company L’s ending inventory fixed at its historical nominal cost for all five years despite rising prices. Memory hook: <em>“LIFO base layer = frozen in time.”</em></p><p>B is incorrect because the newer, higher-cost layers are always consumed in COGS first and do not replace the base inventory.</p><p>C is incorrect because LIFO does not remeasure or revalue layers—it keeps the original acquisition cost unless an impairment or liquidation occurs.</p>

<h3>First Principles Thinking: Growth compounds, it doesn't add</h3><p><strong>B is correct.</strong> Quantity in Year t = initial units × (1 + growth rate)^(t − 1). The PDF states a 10% annual increase. For Year 3, two compounding steps apply: 29,090 × 1.1² ≈ 29,090 × 1.21 ≈ 35,299. Memory hook: <em>“Two years later = (1.1)², not 1.1 × twice.”</em></p><p>A is incorrect because it uses only one period of growth, giving the Year 2 result.</p><p>C is incorrect because it applies three growth periods, producing the Year 4-level quantity, not Year 3.</p>

<h3>First Principles Thinking: Flow over stock</h3><p><strong>A is correct.</strong> Although various turnover formulas exist, the PDF defines turnover explicitly as cost of sales divided by ending inventory. This ratio highlights how aggressively the inventory balance is consumed relative to its carrying value. Memory hook: <em>“Turnover here = COGS / ending inventory.”</em></p><p>B is a valid general textbook definition but not used in the reading’s calculation.</p><p>C is the inverse and would measure something closer to an inventory holding period, not turnover.</p>

<h3>First Principles Thinking: Numerator grows, denominator fixed</h3><p><strong>B is correct.</strong> Turnover = COGS ÷ ending inventory. In the PDF, sales quantities increase 10% annually and unit costs rise 4%, causing COGS to rise quickly. Meanwhile, the firms intentionally maintain a constant 2,090-unit base inventory. Because the numerator rises while the denominator stays stable, turnover increases steadily. Memory hook: <em>“Rising COGS + flat inventory = rising turnover.”</em></p><p>A is incorrect because inflation increases, not decreases, unit costs.</p><p>C is incorrect because no LIFO liquidation occurs; purchases always match units sold (after Year 1).</p>

<h3>First Principles Thinking: Which method keeps older layers in COGS?</h3><p><strong>A is correct.</strong> Under FIFO, older (cheaper) layers continue to flow into COGS even as selling prices rise, widening the spread and raising gross margins slightly. Under LIFO, current costs rise in parallel with current selling prices, keeping margins stable. The PDF’s gross margin table matches this behavior exactly. Memory hook: <em>“FIFO feeds margins with fossil (old) costs.”</em></p><p>B is incorrect because LIFO margins do not progressively shrink—they stay stable because cost and price rise in parallel.</p><p>C is incorrect because fixed quantities do not eliminate cost-layer differences; inventory valuation still diverges.</p>

<h3>First Principles Thinking: Separate valuation from real activity</h3><p><strong>A is correct.</strong> Company L (LIFO) and Company F (FIFO) have identical physical flows in the PDF example. Their turnover difference arises entirely from valuation: LIFO uses lower-cost, older layers for inventory, shrinking the denominator. This makes turnover appear higher even though operational behavior is identical. Memory hook: <em>“Different valuations, same warehouse.”</em></p><p>B is incorrect because both companies sell the same units; inventory method does not change physical flow.</p><p>C is incorrect because turnover remains meaningful; analysts just need to adjust interpretation for cost-flow assumptions.</p>

<h3>First Principles Thinking: Quantity fixed, cost per unit rising</h3><p><strong>A is correct.</strong> FIFO ending inventory is valued at the most recent purchase prices. When per-unit costs rise each year, the same 2,090 units in ending inventory are assigned higher and higher costs. The PDF shows Company F’s ending inventory rising as inflation progresses. Memory hook: <em>“FIFO: Same units, pricier price tags.”</em></p><p>B is incorrect because it confuses physical quantity with valuation. Dollar value changes with cost per unit, not only with units.</p><p>C is incorrect because FIFO sells older, cheaper layers first—not older, higher-cost layers. This would describe deflation, not inflation.</p>

<h3>First Principles Thinking: Under deflation older layers = higher cost</h3><p><strong>B is correct.</strong> In deflation, earlier purchases carry higher costs than newer ones. LIFO sells the newest (lower-cost) units first and retains the older (higher-cost) units in inventory. FIFO does the opposite, pushing older, higher-cost units into COGS. Thus LIFO’s ending inventory exceeds FIFO’s in dollar terms. Memory hook: <em>“Deflation: LIFO keeps the antiques.”</em></p><p>A is incorrect because the inflation ranking reverses under deflation.</p><p>C is incorrect because cost-flow assumptions still change how total costs are split between COGS and inventory.</p>

<h3>First Principles Thinking: Profit = Revenue − COGS</h3><p><strong>A is correct.</strong> Under FIFO, older, cheaper layers flow to COGS, lowering current expense. With identical revenue and non-COGS expenses, lower COGS yields higher operating profit and pre-tax income. The PDF explicitly states that FIFO leads to lower cost of sales and higher income when prices rise. Memory hook: <em>“FIFO inflates profit when inflation inflates cost.”</em></p><p>B is incorrect because FIFO delays the recognition of inflationary costs, rather than accelerating them.</p><p>C is incorrect because the timing—not the total magnitude—of COGS drives period-specific profitability differences.</p>

<h3>First Principles Thinking: Flow divided by stock</h3><p><strong>A is correct.</strong> The PDF defines turnover as COGS ÷ ending inventory. Thus, 500,000 ÷ 25,000 = 20. This indicates that the equivalent of the entire ending inventory value cycles through COGS twenty times in the year. Memory hook: <em>“Turnover = COGS over what’s left on the shelf.”</em></p><p>B is incorrect because it halves the correct value.</p><p>C is incorrect because it understates turnover given the high COGS relative to inventory.</p>

<h3>First Principles Thinking: Margin = Gross Profit ÷ Sales</h3><p><strong>A is correct.</strong> Gross profit = 600,000 − 420,000 = 180,000. Margin = 180,000 ÷ 600,000 = 0.30, or 30%. This matches the structure of margins shown in the PDF’s tables. Memory hook: <em>“Margin is the slice of revenue left after COGS.”</em></p><p>B is incorrect; it would imply COGS of only 360,000.</p><p>C is incorrect; it implies gross profit of 150,000, inconsistent with the given numbers.</p>

<h3>First Principles Thinking: Distinguish economics from accounting</h3><p><strong>A is correct.</strong> FIFO defers the recognition of rising costs by keeping expensive layers in inventory. This inflates income relative to LIFO, which recognizes current higher costs immediately. The PDF warns analysts that FIFO profit partially includes holding gains created purely by inflation. Memory hook: <em>“FIFO profit lifts partly from stored inflation.”</em></p><p>B is incorrect because LIFO’s lower income reflects faster cost recognition, not poorer performance.</p><p>C is incorrect because ignoring the inventory method would obscure real comparability issues.</p>

<h3>First Principles Thinking: Matching principle dominates</h3><p><strong>A is correct.</strong> LIFO uses the most recent, inflation-adjusted purchase costs in COGS. This matches current costs against current revenues, providing a more economically meaningful measure of profit during inflation. The PDF emphasizes that LIFO offers better cost–revenue matching even though it depresses reported profit. Memory hook: <em>“LIFO shows today’s cost against today’s sales.”</em></p><p>B is incorrect because LIFO expends newer, not older, layers; margins fall relative to FIFO.</p><p>C is incorrect because LIFO leaves older, cheaper layers in inventory, making the balance sheet <em>less</em> reflective of current replacement cost.</p>