First-In First-Out (FIFO) Method

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First-In First-Out (FIFO) Method

Definition First-In First-Out (FIFO) Method. Description


The First-In First-Out (FIFO) Method is an accounting and valuation technique for inventories of produced goods, raw materials, parts, components, or feed stocks in which the oldest units available are assumed to be sold, used or disposed of first. Contrary to the LIFO Method, FIFO assumes that an entity sells, uses or disposes of its oldest inventory first.


FIFO follows the principle that materials used should carry the actual experienced cost of the specific units used.

Note that the oldest units may or may not be used in a physical manner: FIFO costing may be used even though physical withdrawal is in a different order.


The term FIFO is also used in Logistics Management to refer to a situation in which the most recent inventory items are physically used first (picture).


Advantages of FIFO Method. Benefits

This means that the ending inventory on the FIFO basis will always consist of the cost of the most recently acquired units. As FIFO charges the oldest costs against revenues on the income statement, this characteristic is often viewed as a deficiency of the FIFO method, since the current cost of replacing the units sold is not being matched with current revenues.

FIFO is one method used to determine Cost of Goods Sold for a business.


Disadvantages or Limitations of FIFO Method

FIFO method is awkward if frequent purchases are made at different prices and if units from several purchases are on hand at the same time. Added costing difficulties arise when returns to vendors or to the warehouse occur.

If Prices are rising, FIFO increases net income because inventory that might be several years old is used to value the cost of goods sold.


FIFO Method Example

The following example may help to understand the FIFO method in detail. Assume that a product is manufactured in 3 batches during the year. The number of units manufactured per batch, the cost per unit and the total cost of production  are as follows:
 

Batch Number Quantity Unit Costs Cost of Production
1 4000 units € 5,00 € 20.000
2 3000 units € 5,50 € 16.500
3 2000 units € 6,00 € 12.000


Now, suppose the company sells 5.000 units during the entire year. Since the total units produced is 9.000, this leaves an inventory of 4.000 items at the end of the year.

Out of the 5.000 units sold, the first 4.000 units cost € 5 per unit (from batch 1).

The next 1.000 units from batch 2 cost € 5,50 per unit. There are also 2.000 units remaining from batch 2, which also cost € 5,50 per unit.

All 2.000 units from batch 3 are left, and these cost € 6,00 per unit.
The remaining 4.000 units will be carried forward to the next financial year at their respective rate. The total will be noted on the balance sheet and the Profit and Loss Statement of the company.


FIFO in US GAAP and IAS/IFRS

However, on the balance sheet, FIFO inventory represents the most recent purchases and, given a reasonably rapid inventory turnover, will usually approximate current replacement cost. The FIFO method is accepted under both IAS/IFRS (IAS 2) and U.S. GAAP (ASC 330) as a valid inventory valuation method.




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