FIFO Method in Accoutning : Work, Calculation & Examples

What is FIFO?

First In, First Out, also known as FIFO, is a valuation method for assets or inventories. Under the FIFO method, the goods that are produced first are disposed of first. The FIFO method is also provided in the Indian accounting standard for inventory valuation. It is the most common, simple, and easy method of inventory valuation used by companies. Under this method, the inventory bought first must be sold first. Assets remaining in inventory are matched with the most recently purchased assets. During inflation, the FIFO method produces a higher value of the closing inventory, a lower cost of goods sold, and a higher gross profit. However, this model does not offer tax advantages, and it also fails to present an accurate depiction of the costs of the inventory when there is a rapid increase in prices.

Geeky Takeaways:

• FIFO stands for First In, First Out, a valuation method for raw materials and inventory.
• In the FIFO method, the goods that are produced first are disposed of first.
• The FIFO method is approved by Accounting Standard 2 and also by the Income Tax Act of 1961.
• The FIFO method creates a system to sell the oldest inventory, which helps the organization reduce the risk of products getting outdated or storing products that are no longer usable, i.e., it is highly used in businesses that deal in perishable goods.

How Does FIFO Work?

1. The FIFO method assumes that the first items manufactured or purchased are the first items sold and that the cost of those items is the cost of goods sold.

2. Since inventory is an essential part of a business, it also impacts the calculation of COGS at the end of the accounting period or fiscal year. Inventory valuation has a significant effect on balance sheets and inventory write-offs.

3. As inflation is present in the market, the more recently procured inventory costs more than the older inventory. While using the FIFO method, since the inventory received earlier is sold first, which typically has a lower value than the recent one, the ending inventory tends to be worth a greater value.

4. Under the FIFO method, the demands are fulfilled from the older inventory, and the cost of such inventory is also calculated at the earlier procured rates. Generally, when any business has a short shelf life, which is perishable in nature, or which tends to go obsolete quickly, the FIFO method comes with the dual advantage of proper inventory management and also provides an easy method for calculating ending inventory value.

How to Calculate COGS in the FIFO Method?

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.

COGS = Number of Units Sold × Cost per Unit of Oldest Inventory

Examples of the FIFO Method

Example 1:

Suppose XYZ enterprise is engaged in the trading of Wall clocks. The monthly demand for Wall clocks is 4000 units. Following is the finished goods layout received from the manufacturer in the month:

Lot 1: 500 Units

Lot 2: 600 Units

Lot 3: 1000 Units

Lot 4: 1200 Units

Lot 5: 700 Units

Following is the order details for XYZ enterprise:

Order 1: 1000 Units

Order 2: 500 Units

Order 3: 500 Units

Order 4: 200 Units

Order 5: 1800 Units

Solution:

Now, When XYZ enterprise is using the FIFO model, their supplies shall be made as follows:

Order 1: 1000 Units (500 units shall be sourced from Lot 1 and 500 Units shall be sourced from Lot 2)

Order 2: 500 Units (100 Units shall be sourced from Lot 2 and 400 Units shall be sourced from Lot 3)

Order 3: 500 Units (500 Units shall be sourced from Lot 3)

Order 4: 200 Units (100 Units shall be sourced from Lot 3 and the balance of 100 units shall be sourced from Lot 4)

Order 5: 1800 Units (1100 units shall be sourced from Lot 4 and the balance of 700 Units shall be sourced from Lot 5)

Example 2:

XYZ enterprise is engaged in the trading business of Wall clocks. Following is the costing for XYZ enterprise month-wise:

Month	Units	Price
August	1000	₹250
September	500	₹280
October	1500	₹275

XYZ Enterprise made its first sale in the month of November by selling 600 wall clocks, XYZ enterprise uses the FIFO method of valuation, and they want to know the cost of the sold units.

Solution:

Since XYZ enterprise is using the FIFO model of valuation, the sold 600 units shall be sourced from the units received in August.

Hence the cost for the same shall be as follows-

Costing = COGS Units

Costing = ₹250 × 600

Costing = ₹15,000

Advantages of FIFO

1. Reduced Chances of Obsolete Products: The FIFO method creates a system to sell the oldest inventory, which helps the organization reduce the risk of products getting outdated or storing products that are no longer usable. FIFO helps the organization reduce waste, ensure that it is not left with any unsold inventory, and mitigate the risk of holding such unsold inventory.

2. Calculation of COGS: FIFO is seen as a great way to calculate the COGS by the management. Also, the FIFO method helps the company calculate the gross margin after selling out its oldest inventory first.

3. Alignment of Inventory Cost with the Market Value: The FIFO method provides a framework for the sale of the oldest product. First, the company determines the value of its in-hand inventory using the recently manufactured items. This helps the organization provide an accurate match of the inventory cost to the current market value and an exact idea of the replacement cost.

4. Fair Financial Documents: The FIFO system provides a precise picture of a company’s financial health, making it difficult for internal parties to manipulate the financial statements. Also, this information helps an organization lay out plans for the future.

5. Reduces the Impact of Inflation: The FIFO method lies in the assumption that the cost of purchasing new inventory is higher than the cost of purchasing old inventory. In the FIFO method, the potential impact of inflation is reduced.

Disadvantages of FIFO

1. Higher Tax Liability: Under the FIFO method, the difference between profit and cost is wide, which can cause the organization to pay a higher tax. So, it is essential that, when using the FIFO method, the organization does not overstate its profits.

2. Clerical Errors: When the organization uses manual inventory recording systems, it becomes relatively difficult for the employees to record the cost of goods and selling prices correctly as there are high price fluctuations. Also, falling or rising market prices can result in discrepancies and clerical mistakes, which can affect inventory and overstate or understate profits.

3. Overstates Profits: When inflation in the market is high, companies that have employed the FIFO method of inventory valuation report higher profits than they earn. This causes a misstatement in the financial statement, and sometimes the accounting records might not disclose the exact result of the organization.

Difference between FIFO and LIFO

Basis	FIFO	LIFO
Method	The method is based on the First in, First Out rule.	The method is based on the Last in First Out rule.
Subject Matter	The method is based on selling those items first that are stored for the longest.	The method is based on selling those goods first that were bought recently.
Ideal For	This method is ideal for those items that are of a perishable nature.	The method is ideal for those items that are of a homogeneous nature and do not have expiration criteria.
Cost Reflection	The FIFO method reflects historical costs.	The LIFO method shows the current market condition.
Result on Inventory	The FIFO method shows an accurate value for ending inventory since older items have been consumed first, while the newest items show the current market prices.	The LIFO method doesn’t provide an accurate inventory valuation as the valuation is much lower than inventory items at today’s prices.
Result on COGS	The FIFO method may result in lower costs of goods sold.	The LIFO method may result in higher costs of goods sold.
Effect on Tax	The FIFO method can lead to paying a higher tax as the gap between profit and cost is larger.	The LIFO method can appear to be a tax-saving method in certain jurisdictions
Effect on Inventory Management	The FIFO method helps to reduce inventory obsolescence.	The LIFO method may result in inventory obsolescence.

Frequently Asked Questions (FAQs)

What does FIFO stand for?

FIFO stands for First In, First Out.

What is the FIFO method?

First In, First Out, also known as FIFO, is a valuation method for assets or inventories. Under the FIFO method, the goods that are produced first are disposed of first. The FIFO method is also provided in the Indian accounting standard for inventory valuation. In the FIFO method, the cost of goods sold comprises the goods produced first, and so on.

What are the advantages of using the FIFO method?

• Reduces chances of obsolete products: The FIFO method creates a system to sell the oldest inventory, which helps the organization reduce the risk of products getting outdated or storing products that are no longer usable. FIFO helps the organization reduce waste, ensure that it is not left with any unsold inventory, and mitigate the risk of holding such unsold inventory.
• Helps calculate the COGS: FIFO is seen as a great way to calculate the COGS by the management. Also, the FIFO method helps the company calculate the gross margin after selling out its oldest inventory first.
• Matches inventory cost to the current market value: The FIFO method provides a framework for the sale of the oldest product. First, the company determines the value of its in-hand inventory using the recently manufactured items. This helps the organization provide an accurate match of the inventory cost to the current market value and an exact idea of the replacement cost.

What are the disadvantages of using the FIFO method?

• Results in higher tax liability: Under the FIFO method, the difference between profit and cost is wide, which can cause the organization to pay a higher tax. So, it is essential that, when using the FIFO method, the organization not overstate its profits.
• Results in clerical errors: When the organization uses manual inventory recoding systems, it becomes relatively difficult for the employees to record the cost of goods and selling price correctly as there are high price fluctuations. Also, falling or rising market prices can result in discrepancies and clerical mistakes, which can affect inventory and overstate or understate profits.
• Overstates profits: When inflation in the market is high, companies that have employed the FIFO method of inventory valuation report higher profits than they earn. This causes a misstatement in the financial statement, and sometimes the accounting records might not disclose the exact result of the organization.

What are the effects of FIFO and LIFO on inventory?

The FIFO method shows an accurate value for ending inventory since older items have been consumed first, while the newest items show the current market prices. Whereas, the LIFO method doesn’t provide an accurate inventory valuation as the valuation is much lower than inventory items at today’s prices.