You probably have an understanding of your inventory, but do you also understand its genuine worth? Effective inventory management involves more than just keeping track of your company's goods.
An accounting technique known as inventory valuation calculates the value of ending inventories and the cost of items sold (COGS). First In- First Out, or FIFO (FIFO), is a frequently used method of inventory valuation widely used to manage inventory.
However, let's first understand FIFO before diving into the crux of FIFO inventory method.
What is FIFO?
- 1.1 What is FIFO Method?
- 1.2 How do you Calculate FIFO?
- 1.3 What are the pros and cons of FIFO?
- 1.4 Pros of FIFO
- 1.5 Cons of FILO
- 1.6 Why pick one method over another?
- 1.7 Who Won?
- 1.8 How is FIFO better than LIFO?
- 1.9 FAQs
What is FIFO?
FIFO is an approach to cost flow assumptions that assume that the first-bought or first-produced products will be sold first.
FIFO operates under the presumption that the first products added to inventory are also the first ones sold and are frequently employed by firms that maintain a physical inventory of some type. Items depart inventories in the same order they entered under FIFO.
When businesses sell older inventory at current, inflated market pricing, they can lessen the impact of inflation and assist the company in selling inventory before it becomes obsolete. Moreover, businesses that use it can also opt for tax minimization strategies.
FIFO is crucial to businesses for the following reasons:
- It Evaluates the cost of the products sold.
- Provide precise budget numbers
- Helps in Evaluating profitability
What is FIFO Method?
The FIFO method is used to make cost flow assumptions. If you use the FIFO approach to make a sale, you're assuming that the oldest stock will be the first to sell.
Since you acquired your oldest inventory, you'll naturally assume that you always sell it first.
"First In First Out"
It is crucial to remember that the FIFO method will provide a higher inventory count during inflationary periods.
The FIFO method is simple to understand, widely used, and trustworthy. The natural flow of inventories is followed by FIFO (The oldest items are sold first, and accounting is based on those expenses). As a result, bookkeeping is simpler and less prone to errors.
International Financial Reporting Standards and Generally Accepted Accounting Principles permit using the FIFO approach. The FIFO method yields the same results with either a periodic or perpetual inventory system.
FIFO method example
Apple employs several inventory management techniques, including the sequential mechanism for accurate inventory monitoring and the FIFO approach. Apple follows the FIFO strategy and markets its oldest models first. This ensures that the company will sell the older stock before introducing its newer ones. It uses FIFO to handle its headphones, iPods, and iPhones.
Apple may significantly limit the accumulation of its outdated items in inventory by implementing FIFO.
What is the Purpose of the FIFO Equation?
The FIFO approach is based on the idea that to prevent obsolescence; a business should sell its oldest inventory products first and keep its newest ones on hand. An entity must be able to explain why it chose to adopt a specific inventory valuation technique, even though the actual method utilized does not have to correspond to the real flow of inventory through a corporation.
The primary purpose of the FIFO equation is as follows:
- FIFO inventory method is the most used technique of inventory valuation internationally.
- Provides firms with a more accurate view of inventory costs by accurately matching the predicted cost flow with the actual movement of items.
- It also lessens the effects of inflation by assuming that the price of buying newer inventory will be greater than the price of buying older inventory.
- Lessens inventory obsolescence.
How do you Calculate FIFO?
To figure out the cost of your inventory that is old and use that cost to compute your cost of goods sold utilizing the FIFO method. Multiply that expense by the quantity of inventory sold. Any variations in the cost of the items through the particular time you are calculating COGS must also be taken into consideration.
John is a toy retailer who started the shop in September last year. Despite just having one store at the moment, he is continually looking to grow his company. To achieve this, he must determine the cost of products sold for the prior year, which he will do by applying the FIFO approach.
FIFO method step by step Calculations
Here is what his inventory costs are:
Month Amount Price Paid
September 200 Toy $200.00 per
October 275 Toy $210.00 per
November 300 Toy $225.00 per
December 500 Toy $275.00 per
Out of his 1275 toys on hand at the time, John sold 600.
John must prioritize the older expenses (of purchasing his goods) while using the FIFO approach.
John's COGS calculations are as follows:
200 x $200.00 = $40,000.
275 x $210.00 = $57,750.
125 x $225.00 = $28,125.
COGS Total: $125,875.
The cost of the goods sold by John is $125,875.
Inventory will be used to account for the remaining unsold 275 Toys.
John may calculate his profit using the cost of the goods sold.
What are the pros and cons of FIFO?
Pros of FIFO
- Simple to use and understand
- Practical when there aren't many transactions, and material prices are dropping.
- Appropriate for heavy materials with high unit costs.
- Assists in preventing degradation and obsolescence.
- The value of the materials' closing stock will be based on the going rate.
Cons of FILO
- If several lots are bought over a while at different prices, the FIFO technique is inappropriate.
- The FIFO system does not allow for the achievement of the goal of balancing current expenditures with current revenues.
- The present manufacturing cost could be inflated if material prices increase quickly.
- The FIFO technique overstates earnings, especially with inflation.
FIFO vs. LIFO
The two most popular methods for determining the cost of products sold out, and inventories are LIFO and FIFO. First in, first out is abbreviated as FIFO, which denotes that the first items entered into inventory are often the first items removed from inventory for sale.
The name "last in, first out," or LIFO, stands for this concept: the items that were most recently added to inventory are thought to be the items that are first removed from inventory for sale.
Why pick one method over another?
The following are some factors to consider:
It stands for first-in, first-out
It stands for last-in, first-out
The FIFO approach is the reverse since it utilizes lower cost figures when computing COGS and believes the oldest goods in your inventory will be sold first.
The LIFO approach is based on the belief that the newest items in your inventory will be consumed first.
FIFO results in a larger closing inventory and lower COGS.
Most of the time, LIFO will cause a decrease in closing inventory and an increase in COGS.
Popularity among Industries
FIFO is more popular since it is a globally recognized accounting concept and because firms often seek to sell their oldest inventory before bringing in new stock.
Businesses with big inventories tend to choose LIFO because it allows them to benefit from larger cash flows and reduced taxes while prices rise.
When expenses rise, the first products sold are the least costly; as a result, your cost of goods sold declines, you report higher profits, and you, therefore, pay more income taxes in the short run.
If expenses are rising, the final products sold will be the costliest; as a result, your cost of goods sold will increase, you'll report fewer profits, and you'll pay less in income taxes in the short run.
For individuals who wish to be as compliant with accounting and legal obligations as possible while yet enjoying better profits and net worth amid inflation, FIFO is the best option.
However, businesses that want to lower their tax obligations and do not prioritize either investing in new projects or acquiring credit at the best rates possible during inflationary times are attracted to LIFO.
While the Generally Accepted Accounting Principles (GAAP) in the United States enable businesses to choose between LIFO and FIFO accounting, the International Financial Reporting Standards (IFRS) only permit FIFO accounting.
The decision between FIFO and LIFO inventory accounting will ultimately depend on your company's requirements and the region in which it is based.
How is FIFO better than LIFO?
Most businesses prefer FIFO to LIFO because there is hardly a good reason to use recent inventory first while letting older stock deteriorate. This is especially true if you sell perishable goods or products depreciating fast.
Moreover, results produced through FIFO are more likely to be precise. This is due to the simpler nature of calculating profit from stock, which makes it simple to update your financial accounts and save time and money. Additionally, it prevents outdated stock from being re-counted or sitting around for so long that it loses its usability resulting in lost revenue and wastage of commodities.
The Bottom Line
Any firm that wants to grow must have excellent bookkeeping practices. Accounting offers us a variety of approaches, but FIFO stands out for its ease of use and viability. Due to its effectiveness in boosting earnings many companies worldwide use FIFO.