Definition
First-in-First-Out (FIFO) accounting is an inventory valuation method in which the costs of products are associated in the order they were acquired, meaning that the oldest inventory items are recorded as sold first. It is mainly used to calculate the cost of goods sold and the remaining inventory value. For example, if a company purchases 10 items for $1 and later 10 more items for $2, and then sells 15 items, under FIFO accounting, the cost of goods sold would be $15 ($1 for the first 10 items and $2 for the next 5 items).
Key Takeaways
- First-in-First-Out (FIFO) accounting is a method used in managing inventory and financial matters which implies that the assets produced or acquired first are the ones sold, used, or disposed of first. In other words, it assumes that assets of a company purchased, or manufactured first, are sold first.
- In environments where commodity prices are rising, FIFO minimizes the effects of these price increases because the items left in inventory at the end of the accounting period under FIFO method are the ones with the highest cost.
- FIFO accounting is generally better for businesses that have perishable goods or units that have an expiration date. This method keeps inventory levels and costs up-to-date, which can help to enhance business and profitability planning.
Importance
First-in-First-Out (FIFO) Accounting is a significant concept in finance due to its influence on inventory management and financial reporting.
It’s a method used to calculate the value of unsold inventory, the cost of goods sold, and other related calculations.
By attributing the costs of the oldest inventory items to the cost of goods sold and the costs of the newest items to unsold inventory, FIFO can impact reported profitability and total asset values.
For example, in a period of rising prices, using FIFO can result in a lower cost of goods sold, therefore higher profitability compared to other methods like LIFO (Last-in-First-Out). Additionally, FIFO provides a more realistic current inventory value on the balance sheet, reflecting the current market conditions.
Hence, it is commonly used in businesses where inventory turnover is rapid.
Explanation
First-in-First-Out (FIFO) accounting is an essential method used by businesses for inventory management and cost flow assumption. The primary reason for using this method is to ensure a systematic approach to calculating the value of unsold inventory, cost of goods sold (COGS), and, ultimately, business profitability. By following a chronological order, FIFO assumes that the items purchased or manufactured first are sold first, thereby maintaining the flow of cost along with its inventory movement.
Hence, the earliest costs remain assigned to the items sold, whereas the most recent costs associate with the unsold items. This method offers a realistic reflection of the current value of inventory, specifically during periods of changing prices, and therefore, it aids organizations in making informed decisions about pricing, marketing, and production strategies. For example, imagine a grocery store that continually stocks and sells apples.
If the store bought 100 apples one week at a price of $1 each and 100 more the following week at a price of $1.50 each, FIFO accounting would dictate that the first apples sold be ascribed the $1 cost. This means that if the store sells 120 apples, the cost of goods sold would be $120 ($100 from the first purchase plus $20 from the second). The remaining 80 apples in stock would be valued at $120, or the 80 apples leftover from the second purchase multiplied by the $1.50 cost. This example helps illustrate how FIFO supports businesses in maintaining an organized, structured method for recording the remaining value of inventory and determining profit margins.
Examples of First-in-First-Out Accounting (Examples)
Retail Businesses: A large retail store that predicts certain goods, such as Christmas decorations, will sell well. It orders an initial stock at a certain price per unit, then restocks at a higher price per unit due to increased demand. Under the FIFO accounting method, it will recognize the cost of the initial, cheaper inventory first. It allows for lower costs and higher profits in the short term.
Manufacturing Firms: A car manufacturing company uses raw materials, like metal sheets, to build their vehicles. If the company bought the first batch of raw material at a relatively lower price a few months ago and the second batch more recently at a higher price due to increased price of metal, in FIFO the company would record the cost of the first, cheaper metal sheets first when calculating cost of goods sold.
Food and Beverage Industry: A restaurant or a bar maintains an inventory of food and drinks, where freshness matters. If they bought a crate of oranges at $20 last week and a second crate for $30 this week, when they sell a glass of orange juice, under the FIFO method, they’ll account for it as being made with the $20 crate first. FIFO method makes sense in this industry, not just for accounting purpose but also from a practical standpoint as perishables need to be consumed in the same order.
FAQ for First-in-First-Out Accounting (Examples)
Q1: What is the First-in-First-Out (FIFO) accounting method?
A1: The First-in-First-Out (FIFO) accounting method is one of the strategies used to calculate the value of unsold inventory, cost of goods sold (COGS), and other transactions. According to FIFO method, it is assumed that the oldest inventory items are sold first, and those remaining in inventory are the newest.
Q2: How does the FIFO method work?
A2: In the FIFO method, the oldest purchase invoices are removed first. For instance, if a business bought 5 units at $10 each and 3 units at $15 each, and sold 5 units, the method will calculate the COGS as (5 units * $10) = $50.
Q3: What is an example of the FIFO method?
A3: Let’s say a company purchased 10 units of an item at $10 each in January, then 20 units at $15 each in February. According to the FIFO method, if the company sold 15 units in March, the COGS will be calculated as (10*$10) + (5*$15) = $175. The remaining inventory cost would be (15*$15) = $225.
Q4: Why do businesses use the FIFO method?
A4: The FIFO method is used because it reflects the most accurate inventory valuation possible. This method assumes that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus, the inventory at the end of the period consists of the goods most recently purchased or produced.
Q5: Does FIFO affect income tax?
A5: Yes, FIFO can affect income tax. A higher inventory value caused by inflation will lead to a higher COGS and lower net income, reducing a company’s tax liability. Conversely, during periods of deflation, FIFO could result in a higher tax obligation.
Related Entrepreneurship Terms
- Inventory Management: This is the method of tracking all the goods that a company has in stock. It plays a significant role in FIFO accounting as the items acquired first are typically sold first.
- Cost of Goods Sold (COGS): This is the total cost incurred to manufacture products sold during a specific period. Under FIFO, the items produced or purchased first get sold first, thus affecting the COGS.
- Asset Turnover Ratio: This refers to the value of a company’s sales or revenues generated relative to the value of its assets. FIFO accounting could impact this ratio due to the chronological selling of inventory.
- Net Income: It is a company’s total earnings, and it’s influenced by the calculation of COGS. In a period of increasing prices, FIFO provides a higher net income by selling inventory acquired at a lower cost first.
- Gross Profit Margin: This is a key financial metric to assess a company’s financial health. Under FIFO, the gross profit margin can be optimized as the COGS is lower.
Sources for More Information
- Investopedia: This website has a vast collection of articles on various finance and accounting topics, including First-in, First-out (FIFO) accounting. It offers a comprehensive understanding of the concept, complete with examples and related terms.
- Accounting Coach: This educational website offers easy-to-understand lessons on various accounting topics. It provides detailed examples and explanations on the application of FIFO accounting.
- Corporate Finance Institute: The website offers a range of free resources on finance topics, including FIFO. These include guides, articles, and lessons that are typically used by finance professionals and students.
- My Accounting Course: A comprehensive learning platform which offers in-depth information and easy to understand examples on First-in, First-out (FIFO) accounting and various other finance and accounting topics.
