First In - First Out (FIFO) - Explained
What is FIFO?
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Table of ContentsWhat is the First In - First Out (FIFO) Accounting Method?How does First In - First Out (FIFO) Work?Illustration of the First In First Out (FIFO) MethodAdvantages of the FIFO MethodDisadvantages of the FIFO MethodAcademic Research on First In, First Out FIFO
What is the First In - First Out (FIFO) Accounting Method?
First In First Out (FIFO), sometimes referred to as Last In Still Here (LISH), is a method of inventory valuation employed in the field of accounting, that is founded on the premise that the sale, usage or disposal of goods follows the same chronological order in which they are bought. In simple terms, the FIFO method mandates that products or assets that have been purchased or manufactured first need to be sold or consumed first. This is often the logical and theoretically correct choice for a business, since disposing of the oldest goods in the inventory on priority greatly mitigates the risks associated with having an obsolete inventory.
How does First In - First Out (FIFO) Work?
A business that follows the First In First Out (FIFO) method updates its balance sheet in such a way that the costs of the inventory assets are matched to the costs of the products most recently manufactured or purchased. It is important to establish here that in a FIFO method, although the oldest assets or products in the inventory are recorded as sold first, it is not always the case that the exact oldest goods present in the inventory are physically disposed at the earliest - it is just that the cost associated with the oldest goods present in the inventory is expended first on the balance sheet.
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Illustration of the First In First Out (FIFO) Method
The concept of FIFO can be easily explained with the help of the following example. A luggage retailer, R1 follows the FIFO method. Now, R1 purchased the following consignments of suitcases in a chronological order during the month of April:
|Number of units||Cost per unit|
Now, suppose that during the same month (April), R1 sold a total of 230 suitcases. In this case, applying the FIFO method, R1 would expend its costs on the balance sheet in the following order:
- Expend the cost associated with the first 100 units @ $100, i.e. 100 x $100 = $10,000.
- Expend the cost associated with the next 120 units @ $105, i.e. 120 x $105 = $12,600.
- Expend the cost associated with the remaining 10 units @ $110, i.e. 10 x $110 = $1,100.
Therefore, the total cost of suitcase sales for the month of April would be ($10,000 + $12,600 + $1,100) = $23,700. Now, R1s ending inventory can be calculated as follows: There are 70 units of suitcases remaining at the cost of $110 per unit. Therefore, the total cost of the remaining units will be (70 x $110) = $7,700. As such, R1s balance sheet will display the current value of the inventory as $7,700.
Advantages of the FIFO Method
The FIFO method offers certain advantages to business, such as:
- The process of application of FIFO is relatively uncomplicated.
- FIFO offers a higher quality information about inventory in the balance sheet, with respect to the current market value of assets.
- It is virtually impossible to manipulate income when using FIFO.
- The assumed flow of costs often corresponds to the actual physical flow of goods to a large extent. Thus, understating inventory is improbable.
Disadvantages of the FIFO Method
Despite the several advantages, the FIFO method also has its share of demerits, such as
- During periods of inflation, the FIFO method displays a higher value for the ending inventory, as well as a higher gross profit (especially compared to a Last In First Out or LIFO method). This results in a higher taxable income for the business and thus, a bigger burden of tax.
- The FIFO method typically results in a poorer matching of costs and revenues, compared to a LIFO method. This is because FIFO expenses the oldest costs first, which often results in revenue from the sale of inventory being matched with an outdated cost.
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- Last-In, First-Out Method (LIFO) – Financial Accounting
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