First in, First out (FIFO), Work, Advantages, Disadvantages

First In, First Out (FIFO) method is one of the most commonly used inventory valuation methods in accounting. Under FIFO, it is assumed that the earliest goods purchased (the first in) are the first to be sold or used (the first out). This method has significant implications for the financial statements, especially during times of fluctuating prices.

How FIFO Works?

Under FIFO, inventory is assumed to flow in the order in which goods are purchased. For instance, if a company purchases inventory in several batches at different prices, the first batch purchased is the first to be sold. The assumption behind FIFO is that goods purchased or produced first are the first to be sold or used in the production process.

Example of FIFO in Action:

Consider a company that buys 100 units of a product at $10 each in January, 150 units at $12 each in March, and 200 units at $14 each in June. If the company sells 200 units in July, the FIFO method dictates that the first 100 units sold will come from the January batch at $10, and the next 100 units sold will come from the March batch at $12.

In this example, the Cost of Goods Sold (COGS) would be calculated as:

• 100 units x $10 (January batch) = $1,000
• 100 units x $12 (March batch) = $1,200

Thus, the total COGS for the 200 units sold would be $2,200.

Inventory Valuation with FIFO:

After the sale, the remaining inventory would consist of:

• 50 units from the March batch at $12
• 200 units from the June batch at $14

Thus, the inventory remaining would be valued as:

• 50 units x $12 = $600
• 200 units x $14 = $2,800

The total value of remaining inventory is $3,400.

Advantages of FIFO

• Simplicity and Transparency:

FIFO is simple to apply and easy to understand. Since it assumes that the oldest items are sold first, businesses can easily track inventory and determine the cost of goods sold.

• Reflects Actual Flow of Goods:

For many businesses, FIFO aligns with the actual physical flow of goods. For instance, perishable items like food, medicine, or fresh produce are typically sold in the order they were received, making FIFO a natural fit.

• Higher Profit in Inflationary Times:

In an inflationary environment, FIFO results in lower COGS because older, cheaper items are being sold first. This leads to higher profits, as the cost of sales is based on older, less expensive inventory.

• Higher Inventory Value:

Since FIFO assigns the most recent, higher-priced goods to the ending inventory, the remaining inventory value tends to be higher during periods of rising prices. This makes the balance sheet more reflective of current market conditions.

• Compliance with Accounting Standards:

FIFO is widely accepted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). This makes it a reliable method for companies that need to comply with regulations and present accurate financial statements.

Disadvantages of FIFO

• Overstated Profit in Inflationary Conditions:

While higher profits may seem beneficial, they can also result in higher tax liabilities because of the increased taxable income. In periods of rising prices, FIFO may not reflect the true profitability of a business, leading to an overestimation of profit.

• Less Matching of Revenue and Expenses:

Since FIFO assigns the oldest costs to COGS, it may not always provide the best matching of revenues and expenses. In periods of inflation, the more expensive goods purchased last may remain in inventory, causing the current COGS to be understated, and profits to be overstated.

• Not Suitable for Businesses with High Volatility:

FIFO may not be ideal for businesses that deal with inventory that fluctuates in price rapidly. In such cases, it may misrepresent the actual cost of sales and the value of remaining inventory, making it harder to forecast and plan.

• Inventory Loss Risk:

As FIFO assigns the oldest inventory first, businesses risk holding onto inventory for long periods before selling. This can be problematic for products that are subject to obsolescence or spoilage, as older inventory may become unsellable or lose value.

FIFO in Practice:

FIFO is commonly used in industries where goods have a natural expiration or where it is more cost-effective to sell older inventory first. Some examples of industries where FIFO is particularly useful:

• Retail:

Retail businesses dealing with non-perishable goods, such as clothing, electronics, and household items, can benefit from FIFO, as it allows them to sell older stock first, ensuring fresh inventory on the shelves.

• Food and Beverage:

In the food industry, FIFO is essential to ensure that perishable items such as dairy, meats, and vegetables are sold before they expire. This helps prevent waste and ensures products are always fresh.

• Pharmaceuticals:

The pharmaceutical industry uses FIFO to manage medications that have specific expiration dates. This helps ensure that older drugs are sold first to avoid selling expired products.