First In First Out is commonly referred to as FIFO and is defined as an accounting system that is used to manage inventory. It also takes care of financial matters that have been tied up within the inventory of feedstock, components, raw materials, and manufactured goods.
First In First Out is a valuation method that is used by companies to track the cost of inventory by assuming that the first product that was purchased will be sold first and in that order only. It assumes that the goods are sold in the same chronological order as it was purchased.
The FIFO accounting method ignores the disparity between the costs of earlier or later purchased units. While making calculations, it assumes the earliest goods are the first ones to be sold and so on.
FIFO is just a cost formula that helps in inventory valuation for perpetual or periodic inventory system. In simple terms, it manages assumptions of costs about stock repurchases and inventory. This is why it is known as asset management as well as the valuation method.
Examples of first in first out
The inventory of ABC Company for January 2018 shows as 100 units for Rs 60, 50 units for Rs, 60 and 100 units for Rs 70 respectively. The company sold 140 units for January.
As per the First In First Out valuation method the total cost of sales for January will be 6000 + 3000 + 7000 = Rs 16000.
The ending inventory for January will be shown as the remaining ten units at Rs 60 and 100 units for Rs 70. Total regaining 110 units for 600+ 7000 + Rs 7600
|Remaining 10 units||Rs 60||600 Rs|
|100 units||Rs 70||Rs 7000|
|Total of 110 units||Rs 7,600|
Shyam ordered ten shirts @ Rs 100 and later five trousers @ Rs 200. It sold a total of 8 units in that month. As per FIFO valuation the total cost of inventory at the onset is (10*100) = 1000 + (5*200) 1000 = Rs 2000.
In the end, its valuation will be Remaining two units at Rs 100 and 5 units at Rs 200 = Rs 1200. It does not matter that he might have sold an uneven number of shirts and trousers, but as per the FIFO method, it has now seven units left at a cost price of Rs 1200 for all the seven units.
8 Advantages of first in first out
The several advantages of using First In First Out are as follows-
- The most important advantage of First In First Out is that it is accepted by regulatory authorities and standards, for example, GAAPs and IFRSs.
- First In First Out (FIFO) follows the natural way of maintaining records. The recording of inventory is done as soon as the products are either manufactured or purchased hence maintaining its exact order. This is one of the easiest methods that everyone can easily relate to.
- First In First Out is applicable in organizations that boast of inventory that converts quickly and has a fast. Its benefit is that the cost and revenue are shown from the related period and thus prove advantageous for the company.
- The most recent buy is shown as the last figure. You can just have a glance at it and get an estimate of the similar products at that date and make viable comparisons between the products.
- The oldest products are already accounted for under the heading COGS, and the risk of reduced NRV are mitigated automatically. This is because the business is not affecting the inventory records. Moreover, the number of records that need to be maintained also decreases because of First In First Out.
- The value of a closing stock is necessary for accounting ratios and the current asset total. The inventory value at the end can help the organization to get a reliable analysis of the current figures.
- The inventory which is purchased is listed along with its respective cost. It becomes easier for the interested parties to ascertain about the batch by looking at the inventories that were issued as well as held in the warehouses
- The prices are always on the rise because of inflation. Although the inflation results in increased operating expenses, it will also result in an increase in ending value of inventory, and this will simultaneously increase your gross profit figure.
6 Limitations of first in first out
The limitations of First In First Out valuation method are as follows-
- If someone places an order or you are buying in bulk with fluctuating prices, then it becomes very difficult to maintain the First In First Out valuation method. The process which seemed easier now becomes complex and prone to error.
- It requires additional work to adjust for inflation and several other factors for the oldest inventory.
- Under inflationary economies, the cost of sales value is not reliable for calculating costing decisions. The prices at the beginning of the year are quite different from those at the end of the year. The cost is thus not as per the current market conditions.
- If an organization buys in bulk at the beginning for the whole year, the inappropriate sales figures are enlarged. This forces the company to spread its procurement process over the whole period to avoid higher ordering cost.
- The First In First Out method requires both the cost and revenue to match and report in the same period. If they turn up for different period because of slow turnover or slow converting rate, then it can cause difficulties for the management in calculations.
- The value of inventory may show an increase even if the physical counting has decreased due to inflation. This results in bloating as there is no real value to back up.