Replacement Cost

Investors should routinely make sure they understand how the companies they are considering account for their inventories.  Recent, politically driven allegations of oil industry profiteering, suggest that a better understanding of inventories, accounting and replacement costs, may be appropriate.

Generally, most companies use either the Last-In, First-Out (LIFO) method or, First-In, First-Out (FIFO) method in accounting for inventories.  LIFO assumes that the last unit to arrive in inventory is sold first.  FIFO, the most logical choice, assumes the oldest unit in inventory is sold first.  However, this is just accounting, and does not represent the timing of the actual transfer of goods, which occur at market prices.

For an oil company using FIFO accounting, current sales, which are at market, may have an inventory cost basis relating to finding and developing costs incurred years ago.  As a result, in the current boom market for oil and gas, reported profits are high.  However, physically replacing the inventory will reflect current, not historical, market conditions.

That’s accounting.  In the real world investment analysis is based on replacement cost.  In other words, it doesn’t matter what you paid for something, your selling price should reflect replacement cost, that is, current market prices. 

For example, if you were fortunate enough to have bought your home years ago for half the current market, that doesn’t mean you are going to sell at that price.  After all, you’re still going to have to live somewhere, so both your sale and subsequent purchase are going to reflect current market conditions.

Remember, accounting reflects the past, while investing is the future.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA