In America, a company can calculate its cost of goods sold by employing either the FIFO (First-In, First-Out) technique or the LIFO (Last-In, First-Out) technique. Both are acceptable, although this LIFO technique is frequently discouraged since recordkeeping is significantly more complicated and the technique is easily manipulated.
FIFO inventory cost technique
While the FIFO method is valued by investors and global banks since it is a straightforward approach to determining the cost of goods sold. Due to its simple structure, it is also simpler for managers when it comes to accounting records. It also implies that the business will be able to report more revenue, making the company more appealing to prospective investors. Finally, a more precise figure for existing stock can be delegated. So, what is the FIFO inventory cost method? Let’s learn about it in the below parts.
Contents
- 1 The Definition Of The FIFO Method
- 1.1 Way To Calculate The FIFO Method
- 1.2 Benefits Of The FIFO Method
- 1.3 Drawbacks Of The FIFO Method
- 1.4 How To Calculate The Inventory Cost By Using The FIFO Method?
- 1.5 What Are The Other Methods Beside The FIFO Method?
- 1.6 LIFO Method
- 1.7 Average Cost Inventory Method
- 1.8 Specific Inventory Tracing Method
- 2 Conclusion
The Definition Of The FIFO Method
FIFO is an abbreviation for “First-In, First-Out” and is applied to calculate cost flows. The technique of transferring the cost of a business and its productions from its inventory to its cost of goods sold is referred to as cost flow assumptions. FIFO is one of many methods for calculating inventory costs in a company, along with LIFO and average cost are two other popular inventory methods for calculating inventory cost.
As products move to the next stage of development and completed stock products are sold, the costs involved with that good or service must be considered an expense. The inventory cost acquired first will be supposed to be noticed first under FIFO. Since the stock has been removed from the company, in this case, the money value of inventory holding declines during this phase. Inventory cost can be determined in a number of different ways, one of which is the FIFO technique.
Inflationary marketplaces and rising costs are sensitive to economic situations. If FIFO is applied to the cost of goods sold in this case, the oldest costs will possibly be considered lower than the latest current inventory purchased at the latest higher costs.
Because of the lower expenses, net revenue is higher. Furthermore, since the most recent inventory was purchased at higher costs, the ending inventory amount is enlarged.
FIFO definition
Way To Calculate The FIFO Method
FIFO is calculated by multiplying the COGS by the number of units sold.
fifo method formula
The term “inventory sold” relates to the price of goods purchased (for resale) or the cost of manufactured products, which contains labor, raw materials, and manufacturing overhead costs. Note that a firm’s inventory prices frequently vary. These rising and falling costs must be considered.
For example, if a company sells 100 items and initially bought 60 items at $5 and 40 items at $10, the firm cannot allocate the $5 cost price to all items sold. Only 60 items are available. The remaining 40 products must be priced at a higher rate of $10. Finally, the item must have been sold in order to be included in the equation. Unsellable inventory cannot be factored into the cost of goods computation.
Benefits Of The FIFO Method
The FIFO technique is common among companies since it is simple to understand and apply. This implies that statements are more straightforward, and provide an extremely accurate view of a company’s financial situation. This data assists a company in planning for the future.
Furthermore, this technique follows the natural inventory flow. Most business owners choose to sell their oldest products first, recognizing that they will drop in value because of long-term storage. Because the unsellable goods are also the latest, the firm’s records will better represent the value of the existing stock.
Some main benefits of the FIFO techniques are:
- The method is simple to grasp, commonly recognized, and believed.
- FIFO is based on the normal flow of stock. This simplifies bookkeeping and reduces the possibility of errors.
- Reduced waste
- The remaining inventory will provide a more accurate representation of the market price.
- Increased profit
- Accounting records are more difficult to alter.
Drawbacks Of The FIFO Method
However, there are certain drawbacks. Since the difference between profits and costs is larger with the FIFO technique, a company may have to pay more income tax (than LIFO). A business must also exercise caution when using the FIFO technique to avoid overestimating revenue. This can occur when item costs go up and later figures are included in the cost of goods calculation rather than the actual expenditure.
Some main disadvantages of this technique are:
- The business’s profits may be overstated due to the difference between revenue and costs
- Higher income taxes rate
How To Calculate The Inventory Cost By Using The FIFO Method?
The FIFO technique is used to determine inventory costs as follows. Suppose a product is manufactured in 3 batches throughout the year. The expenses and volume of each batch are as follows:
| Batch | Quantity (pieces) | Cost to produce |
| 1 | 5000 | $15000 |
| 2 | 2000 | $10000 |
| 3 | 3000 | $12500 |
| Total | 9500 | $37500 |
Example table
Following that, you must determine the manufacturing costs for every batch produced.
| Batch 1 | $15000 / 5000 = $3 |
| Batch 2 | $10000 / 2000 = $5 |
| Batch 3 | $12500 / 3000 = $4.16 |
Example price for per unit table
Assume you sold 6000 items from the 9500 manufactured throughout the year. You have no idea which parts were sold at what price. Under FIFO financial reporting, the cost of units sold is calculated by assuming that the oldest (first-in) manufactured products were sold first. Thus, utilizing the FIFO technique to calculate the 8000 items sold.
Suppose all 5000 of the $3 items in Batch 1 were sold first. The first 5000 items sold in Batch 1 were $3 each which comes to a total of $15000.
Cost of first 5000 items sold in batch 1
The next 2000 items from Batch 2 sold for $5 each, for a total of $10000.
Cost of 2000 items sold in batch 2
And the final 1000 items from Batch 3 sold for $4.16 each, which was a total of $4160.
Cost of 1000 items sold in Batch 3
When all of these costs are added together, we will have the total cost of the 8000 units sold as $29160.
The total cost of 8000 items sold
What Are The Other Methods Beside The FIFO Method?
Besides the FIFO technique, there are also different techniques that we can use, including
LIFO Method
LIFO is the inventory costing technique that is the inverse of FIFO in that the latest product purchased or obtained is the first product out. Once especially in comparison to FIFO, this leads to deflated net revenue expenses and lower inventory ending helps to balance in higher inflation economies.
Average Cost Inventory Method
The average cost inventory technique charges the same price for every item. The average cost technique is computed by dividing the cost of inventory goods by the total number of products for sale. This leads to net earnings and inventory balances at the end of the FIFO and LIFO periods.
Specific Inventory Tracing Method
Lastly, once all elements contributing to a final product are recognized, proper inventory traceability will be used. If all of the parts are unknown, any technique other than FIFO, LIFO, or average cost is suitable.
Conclusion
The First-In-First-Out or FIFO technique is a standard accounting technique that supposes resources are sold within the same order in which they are purchased. In certain states, all businesses are required to accept responsibility for inventory using the FIFO inventory cost method. Even in cases where it is not considered necessary, it is a popular standard owing to its simplicity and accountability.
