What does FIFO mean?
It is the technique used to calculate the costs of goods sold to make assumptions about cost flows. The FIFO method assumes the oldest products in the firm’s inventory were sold first. The fees paid for these most senior products are used in the calculations.
How Do You Calculate FIFO?
To calculate your COGS (cost of goods sold) using the FIFO method, identify your old stockpile value. Multiply this cost by the number of items sold. The “inventory sold” is either the cost of buying goods (with the intent of selling them again) or the cost of producing goods (which includes the costs of labour, materials, and overhead for manufacturing). Remember, the prices that companies pay for their inventory are usually subject to fluctuations.
These fluctuating costs need to be taken into consideration. For example, if the company sells 100 units of a good, 75 teams were initially purchased at $10.00 by the business, but 25 units were purchased for $15.00, then they cannot attribute a $10.00 cost per unit sold. The remaining 25 teams would have to be assigned the higher cost, $15.00. Finally, a product must be sold to be used in the equation. You cannot add unsold inventory into a calculation for the cost of goods.
What Are the Advantages of FIFO?
The FIFO method is considered by me a much more reliable approach than LIFO (“last-in, first-out”) methods. You can read more on why the FIFO is preferred here. The approach is simple to understand, widely accepted, and trusted.
FIFO follows the natural inventory flow (older products are sold first, and the bookkeeping goes from these costs out first). This makes bookkeeping more accessible, and there is less potential for errors. Less wastage (a business that follows FIFO methods will permanently get rid of the oldest stock first). The remaining products in stock will reflect the market value better (this is because products not selling were built recently).
Financial statements are harder to manipulate. The FIFO approach gives an exact picture of the finances of the business. This information helps the company to plan its future.
What Are the Disadvantages of FIFO?
The FIFO method may lead a company to pay higher income taxes, as the difference between costs and profits is more significant (than under LIFO). A company must also take care when using the FIFO method to ensure it does not overstate profits. This may occur when the costs of products increase, and these subsequently used numbers are used in calculating the cost of goods rather than actual costs.
Why Would You Use FIFO over LIFO?
In the U.S., the firm has a choice to either use a FIFO (“first-in, first-out”) or a LIFO (“last-in, first-out”) method in computing the cost of goods sold. Both are legal, though LIFO is generally discouraged as accounting is much more complicated and the process is easier to manipulate. Corporate taxes are cheaper for the business using the LIFO method as LIFO allows a company to use the most recently produced costs first. Usually, those costs are higher as the years go by.
Lower profits can mean a tax deduction. However, this can also make the business less attractive to investors. The value of remaining inventory, assuming it is nonperishable, is also underestimated under LIFO, as companies are going with the old costs of purchasing or producing this item. That more aged inventory might, in fact, stay on the books forever.
Investors and banks appreciate FIFO as a transparent way to compute the cost per item sold. It is also easier on the management side of accounting due to its simplicity. It also means that a business can claim higher profits, making the business appealing to prospective investors. Finally, more precise numbers for the remaining inventory can be assigned.
Outside of the U.S., several countries, such as Canada, India, and Russia, must follow the rules established by the IFRS (International Financial Reporting Standards) Foundation. IFRS provides the basis of internationally accepted accounting standards, requiring all companies to compute the costs of goods sold using the FIFO method. Many businesses, including U.S.-based companies, have decided to go with FIFO.
