Phantom profits are earnings generated when there is a difference between historical costs and replacement costs. The issue most commonly arises when the first in, first out (FIFO) cost layering system is used, so that the cost of the oldest inventory is charged to expense when a product is sold. If there is a difference between this historical cost and the current cost at which it can be replaced, then the difference is said to be a phantom profit.
For example, a company sells a green widget. The firm uses the FIFO cost layering system, and the oldest cost layer for the green widget states that the widget costs $10. The widget sells for $14, so the profit appears to be $4. However, the replacement cost of the widget is $13, so if the widget had been sold at replacement cost, the profit would instead have been $1. Thus, the $4 profit using FIFO is comprised of a $3 phantom profit and a $1 actual profit.
Managers need to be aware of phantom profits, especially when there is a substantial difference between the old cost layers and replacement costs. Once the old cost layers have been eliminated, managers may find that their reported profit levels suddenly decline.
When a business uses the last in, first out (LIFO) cost layering system, the most recent historical costs are charged to expense first, so there should be little difference between these costs and current replacement costs. Thus, phantom profits tend to be reduced in a LIFO environment. The one exception is when the newest cost layers are used up and earlier cost layers are accessed, in which case phantom profits are more likely.