Inventory management is an important component for any business that deals with physical products. Managing your inventory effectively can lead to cost savings and increase profitability. One of the key methods that is used in inventory management is the Next In, First Out (NIFO), which usually helps at the time of product replacement. In this article, explore what NIFO is, its advantages and disadvantages, and its examples.
What Is Next In, First Out?
When it comes to Inventory management, companies use several methods to achieve maximum results. One of the lesser-known methods but extremely valuable is the NIFO, Next In, First Out. It is used to evaluate the replacement cost of an item rather than its original cost. Next In, First Out is a variation of the more common First In, First Out (FIFO) and Last In, First Out (LIFO) inventory methods. Let's understand what is Next In, First Out with its advantages and disadvantages.
Understanding Next In, First Out
The NIFO method is usually used by companies where inflation is a factor. The inventory management system prioritizes the most recent items before the older ones. The thing you need to note is that the NIFO method doesn't come under any of the accounting frameworks like GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). So, it can't be used in any financial preparation. Then why do economists and businesses prefer to use this method for economic rationale? Because it is related to the traditional FIFO method, which uses the old item first, and LIFO, which uses the last item first, when any new item is added to the inventory, the business considers it to be the first one to be used or sold. This means the cost of the most recently purchased items is reflected here as the cost of goods sold (COGS).
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Advantages of Next In, First Out (NIFO)
With its immense usage of Accounting purposes, NIFO also comes with various advantages. Below, we have mentioned some of the benefits that can help you.
1 Reflect Current Market Prices
The Next In, First Out is commonly used for internal reporting purposes during high inflation. The NIFO is used in valuing inventory, which is particularly beneficial for industries where raw material or product prices are uncertain.
2 Strategic Pricing
The Next In, First Out method helps companies to understand the market condition and needs. Using this NIFO inventory valuation method, they can make informed decisions keeping inflation in regard and accurately reflecting their current cost structure.
3 Higher Profit Margins
The NIFO allows businesses to use the most recent inventory cost, which may help them to report higher profit margins. This can be beneficial for financial reports and inventory management.
4 Tax Benefits
The last benefit that comes with Next In, First Out is the lower taxable amount. As we have discussed earlier, the goods sold are calculated in higher or more recent costs that may reduce the company's tax liability.
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Disadvantages of Next In, First Out (NIFO)
You can benefit from various advantages when it comes to accounting with Next In, First Out. Still, there are several disadvantages you need to deal with while maintaining your inventory, which are explained below.
1 Reduced Historical Tracking
The first that comes with NIFO is its volatile nature, which makes it difficult to track the original cost. This means that due to inflation, the replacement cost significantly changes and makes it challenging to calculate the original purchasing cost of the product. As a result, this type of inventory valuation system impacts the financial analysis and account audit of the company.
2 Complex Accounting
NIFO is challenging for historical inventory tracking because the price of the product keeps on changing due to inflation. It makes it challenging for accounting as compared to FIFO and LIFO.
3 Inventory Valuation Fluctuations
The inventory valuation can significantly fluctuate with Next In, First Out due to the increasing price of the product and manufacturing cost with time. This fluctuation in price can make it difficult to generate financial statements.
4 Potential For Manipulation
Like LIFO, the Next In, First Out method can manipulate the tax and financial reporting purpose, which may raise ethical and legal concerns.
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Example for Next In, First Out (NIFO)
As described above, the NIFO method is rarely used. The best example can be the seasonal demanding products that have higher replacement rates from end sellers. Suppose there is a gift manufacturing company that wants to sell idols at the rate of Rs.500 for each piece. At this rate, the company will make a profit of Rs. 250, whereas the production cost is also Rs.250. This means the total profit is 50%. Now, the end seller asks for the replacement at the increased market value. In that case, if the NIFO method is followed, the company will mark less profit while accounting. For instance, it can be Rs. 300 selling price and Rs.200 profit. Next In, First Out is the right inventory management for the business, which depends upon industry dynamics, turnover rates, and accounting objectives. Before using the NIFO method for your inventory management, it is essential to consider the pros and cons. Also, invest in the best tools to make the inventory tracking process easier. And talking about the best tools, TranZact can be your best option for NIFO inventory tracking and effective accounting.
FAQs
1. Why would you use Next In, First Out (NIFO)?
The NIFO method is particularly used in industry dynamics where inflation is the biggest factor. If you belong to such an industry, then it can be beneficial for you.
2. Which inventory method is best?
Choosing the best inventory valuation method depends upon the industry you are involved in. If your company is operating in a sector where the market is extremely volatile, NIFO can be the ideal option for more profit in product replacement.
