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Full Form of FIFO

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How Does it Work?

It is used in the costing method. When there are multiple items in the inventory that require to be allocated for particular products, the products purchased or bought earlier would be considered to collect the cost for the product. If used to calculate the inventory cost, the first product used for the goods would be regarded as the expense.

How to Calculate FIFO?

To calculate FIFO, the price of the oldest inventory needs to be traced, and then the cost prices of each unit are multiplied by the units of inventory sold. Then the amount arrived would be the inventory price, and the remaining raw material units would be used for the next inventory sales.

Example

To arrive at the cost of sales, inventory plays a significant part. An inventory constitutes multiple products or items or self-made goods of the company. So, let’s assume article A has used raw material for product Y. The Y has 10000 pieces in the finished goods segments, and within the production span, the company has bought X twice in a lot of 4000 pcs each. The first 7000 of X cost the company $10 each, and the remaining 7000 cost $12 each. So, for calculating the price of Y for the first 10000 units, a $10 price would be considered for the first lot of 4000 pieces and $12 for the remaining 6000 pieces.

Other Methods

There are various other valuation methods except for FIFO, such as LIFO and the Weighted Average inventory method.

LIFO is considered as last in, first out. It is generally used in the inflationary economy due to consistently increasing prices. It helps in the price checking function of the goods and thus reflects a better inventory pricing and keeps the profits in the check.
Another widely used method apart from FIFO is the Weighted Average. Weighted Averages put weights on the prices of products when these are purchased. Also, In a way, it averages out the prices and removes the bias of earlier or later buys. It helps provide the real picture of the profits and losses in the financial statements.

Difference Between FIFO and LIFO

LIFO or Last In First Out is the opposite of FIFO or First in First Out. In LIFO, the most recent inventory is used to calculate the Cost of Goods Sold. This method could be used once the inventory cost rises over the period, and most probably, the cause is inflation.
If the FIFO method were used, the cost of goods sold would be comparatively lower than the current market prices and would reflect higher profit. The LIFO method is used to resolve the mismatch of prices in such situations.

Advantages

In maximum industries, FIFO is used because there is no alarming situation where inflation is rising at a higher pace or the prices of the goods have suddenly shot up.
In another situation, the FIFO works well because it shows the real cost position as used by the management. It is based on the principle that goods have a shelf life, and if the goods that arrived earlier were not used, they would perish or lose their quality. So, to apply that in the costing world, the FIFO method is also used.
It also helps to rule out products that came earlier than others to remove the possibility of minimizing the wastage by taking goods that arrived in chronological order.
Again, it is a simple idea, and anybody with even a layman’s brain would be able to understand it. It is like deducting on a priority basis of arrival. It is widely used and thus removes the inconsistencies faced by using different methods.
It removes the manipulation in the accounts as the records available would certify the costs received earlier. Again, most of the time, if the prices are increasing in the market, FIFO tends to increase the entity's profit, as the goods that arrived earlier must have been bought at a lower price.

Disadvantages

A few disadvantages of the FIFO method are as follows:

One of the biggest drawbacks of FIFO is that it tends to inflate the profits in a scenario of rising stock prices or a high inflation economy. As the prices are rising consistently, FIFO would calculate cost based on the earlier purchased product, which would not provide a fair picture in the financial statement.
The idea seems simple to apply, but sometimes the increased number of products used for preparing a product requires a lot of calculation. It becomes very clumsy to arrive at the price of the earliest stock and derive the first product sometimes leads to clerical errors.
It only works well if the prices of the goods remain in one zone or do not increase or decrease on multiple bases. It is also challenging to get into an economy that provides precisely similar prices for the products.

Conclusion

Though the FIFO has some disadvantages in the inflationary price movements, it still provides a lot to the valuation world. The simplicity, wide acceptance, and better presentation of the financial records pose a better valuation option than many methods. Also, it is being approved by various tax authorities across nations, making it a suitable choice in selection policies of valuation.