Not all SME businesses are fully aware of what is FIFO method of inventory calculation and they tend to rely on manual methods to evaluate their inventory. FIFO also referred to as the First-In, First-Out method, is used for the cost flow purpose in calculating the price of the goods sold.
This method works on the assumption that the products which are older in the company's inventory must be sold first. The price paid for the older products is used for the calculations. So let's explore more about what is FIFO method.
What Is FIFO Method With Example?
The First-In, First-Out (FIFO) method is the valuation method or asset management method in which the assets acquired first or produced first are used, sold, and disposed of. For tax purposes, the FIFO method assumes that the asset with the oldest price is used in the income statement of COGS or cost of goods sold.
Within this method, existing inventory is compared with inventory that is newly bought or made. In manufacturing, the items are progressed to the developmental stages. Later, the finished items are sold, and the cost associated with the product formed finally is considered as the expense.
So, in short, in First-In, First-Out, the price of the purchased inventory is recognized first. The total inventory value starts reducing later on in the process. There are various ways to calculate the inventory cost, but the FIFO method is the best. The major economic situation includes rising prices and an inflationary market. So in such cases, if the FIFO assigns the oldest price to COGS, then this assigned cost will be lower than that of the inventory purchased recently at the actual inflated price. Now let's see the FIFO example.
Example of FIFO
A business called Fresh Food purchased 80 boxes filled with oat treats at a price of Rs. 30 for each box. Later, it purchased another 150 boxes of the same oat treat, but this time the cost of each box was Rs. 40 as the supplier had increased the price. Now Fresh Food has 230 boxes in stock. Out of this, it sells 100 boxes.
In conclusion, in this FIFO method example, Fresh Food utilizes the initial price of 80 boxes which is Rs. 30 for each box, which equals Rs. 2400.
80 boxes x Rs. 30 = Rs. 2400.
However, for the leftover 20 boxes of the order received, it considered the price of each box as Rs. 40. So the cost of the remaining 20 boxes of the order is Rs 800.
20 boxes x Rs. 40 = Rs. 800
The total FIFO cost for this order is Rs. 2400 + Rs. 800 = Rs. 3200
What Is the FIFO Method in Accounting?
FIFO is the accounting method where the acquired and purchased assets are disposed of first. It assumes that the remaining inventory consists of products or items purchased at the end. Suppose we talk about inventory accounting, then there lies a big difference between the results of LIFO and FIFO. Your inventory management method would impact the tax payment and financial results. Here are a few things which you need to consider while looking for the FIFO method in cost accounting:
Good for keeping records:
When the oldest inventories are prioritized for usage, it will lead to a reduction in record keeping. Also, keeping track of the inventory value and product gross profit becomes easier with FIFO.
Inflation would affect the tax:
The initial price of inventory would be lower than the price or cost of the product purchased later. At the same time, the price of selling the product would be higher. It means that the new item if purchased will be higher in price. It can lead to profit loss and higher tax rates.
There is no restriction for the financial reporting:
The FIFO method considers the required financial reporting standards in the financial reporting.
What Are the Benefits of FIFO?
First-In, First-Out is one of the most popular methods for the accounting purpose of the inventory. There are various advantages of the FIFO method. From providing proper inventory tracking to ensuring the best service to the customer, FIFO is more beneficial than the other methods. Here is the list of benefits of FIFO method:
Software compatibility:
Various accounting software use the FIFO method for inventory as it is compatible with various business functions. Even if you consider other methods, you will find that they are more expensive than FIFO.
Accurate analysis of cost:
The FIFO method provides an accurate picture of how much the cost of inventory is for your business. It aligns current business costs with the actual cost of goods. This method provides accurate results as compared to the other methods. It ensures real-time analysis and better accounting.
Easy to apply and use:
When using the FIFO method, one can apply inventory best practices by properly managing the cost of inventory.
Calculation of higher cost:
It accounts for scenarios when the price of products and goods increases with time.
Due to the flow of goods, the strategy is quite simple:
This FIFO accounting system is a very simple approach for staying on top of your stock costing because of the cycle of selling and purchasing stock. Additionally, this will make the COGS calculation considerably easier.
So these are some of the advantages associated with the FIFO system. Now let's understand the difference between LIFO and FIFO.
What Is the Difference Between LIFO and FIFO?
The method for inventory valuation opposite to that of FIFO is known as LIFO. In this method, the newest item acquired or purchased is out first. This results in a deflection of the gross or net income, reducing the ending balance of the inventory compared to that of FIFO.
Apart from this, there are other major differences between LIFO and FIFO. At the time of price increase, the item sold from the inventory is assessed at high COGS under LIFO. In such conditions, the company's expenses are usually higher, which means the total income is less in LIFO during inflationary periods. In short, under LIFO, more expensive items are sold. The lower prices result in high income as the new inventory is purchased at high prices so that the final inventory balance would be inflated.
FIFO Method of Inventory Valuation
It depends on assumptions that the use and sale of goods are based upon the order in which the products are purchased. In simple words, in the FIFO method, purchases of products and goods are removed and sold first. Therefore, the cost of recent goods is added to the balance sheet, whereas the old cost is already expensed first. The FIFO inventory method is important because of the following reasons:
Impact on the price of the goods sold:
At the time of ending inventory, higher valuations are recorded. As a result, the price of the products sold increases comparatively slowly and leads to better profit levels.
Impact on multiple periods:
FIFO method ensures accuracy in inventory valuation and helps to avoid incorrect calculations and incorrect profit numbers.
Leverage Automated FIFO Inventory Calculation on TranZact
Product-oriented organizations utilize various inventory methods, which help them calculate their stock.
In this article, we have seen what is FIFO and why FIFO is one of the accounting system's most widely used accounting methods for inventory pricing. It also helps to relate to how inventory moves through your store or warehouse, to manage inventory easily.
TranZact offers a dedicated inventory solution with the simplest and easiest inventory method of FIFO to streamline inventory functions for SME businesses.FAQs on FIFO Method
1. Why is FIFO the best method?
It is referred to as one of the finest methods used for accounting inventory as it can be easily understood and utilized. It can also lead to high-profit generations that impress potential buyers and investors. When it is automated using a software, it further simplifies stock costing calculations.
2. What is the FIFO system?
The FIFO system, also known as First-In, First-Out, is a stock or inventory management method where the oldest stock is sold or consumed first. This helps to ensure that goods are not left behind and they do not expire before they can be sold.
