The way inventory is valued depends on how the stock is tracked over time by the company. Valuation is a must for any business. Inventories are constantly sold and restored and their prices change continuously; therefore, the company must standardize the method to avoid errors and incorrect accounting.
Inventory valuation can be done using one of the following methods:
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Weighted Average Cost
- Specific Identification
This article focuses on the FIFO method which we discuss in detail in the next sections.
What this article covers:
- What is FIFO
- Why is FIFO important
- Example of FIFO calculation
- Benefits of FIFO
What is Inventory Valuation?
Inventory valuation can be defined as the amount correlating with the goods in the inventory at the end of the reporting or accounting period. This value is generated after considering the expenses incurred to acquire the stock and preparing it for sale.
This valuation or amount is entered in the balance sheet as a current asset. The inventory valuation could include these aspects:
- Cost of inventory
- Costs of labor
- Factory Overhead
- Freight charges
- Handling charges
- Import duty charges
It is good to know about inventory valuation as it has a major impact on the profits. Arbitrarily, the costs are a total of acquiring, conditioning (for sale) and transporting it to the location of sale. These costs, however, do not comprise admin charges or selling costs.
What is FIFO?
FIFO stands for First In First Out. FIFO in inventory valuation means the company sells the oldest stock first and calculates it COGS based on FIFO.
Simply put, FIFO means the company sells the oldest stock first and the newest will be the last one to go for sale. This means, the cheapest stock will be sold first and the costliest stock will be the last; it will form the ending inventory. In the process, FIFO enhances the net income as the cheaper older inventory will be used to confirm the current cost of the sold goods. However, the company will have to pay higher taxes for a higher income.
The FIFO approach yields a higher value of the final stock, lesser cost of goods sold, and greater gross profit during inflation. This is because in an inflationary market when FIFO is applied, the old stock cleared first leaves behind the costlier items in the balance sheet, to be sold at a higher price in the future.
This method is used when a cost flow assumption has to be made. Considering manufacturing, as goods move towards the last stages of development and as stock in the inventory gets sold, the cost related to the product must be identified as an expenditure. When working with FIFO, the cost of the inventory bought first will be identified first.
The International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) also endorse FIFO for the valuation of inventories.
Why is FIFO important?
Maintaining professional bookkeeping practices is a must for the growth of any business. With accounting presenting us with diverse methods, FIFO stands out due to its simple approach and feasibility. FIFO is a type of accounting technique that helps organizations value their inventory at the end of an accounting or reporting period. It is important to the businesses for the following reasons:
- Determines cost of goods sold
- Provides exact numbers for budgets
- Evaluating profitability
Knowledge about these factors lets the company estimate the value of its stock.
Examples of FIFO
With an understanding of FIFO, let’s see a few illustrations which reinforce the concept.
We shall consider 2 scenarios: one where the cost increases and the other where the cost decreases with time.
Scenario 1: Cost Increases with Time
This scenario deals with the inventory costs increasing with time.
We shall assume Dan’s has a store that sells music systems and has been operational since September.
Here are his inventory cost details:
He acquired a total of 300 units where 1 unit = 1 Music system
We see that the price of the units consistently increased.
Let's assume that total music systems he sold = 200.
Let’s calculate the cost of the goods sold using FIFO.
Dan’s Cots of Goods Sold is:
50 units x $800 = $40,000
50 units x $800 = $40,000
50 units x $875 = $43,750
50 units x $875 = $43,750
Dan’s cost of goods sold = $167,500
Scenario 2: Cost Decreases with Time
Let’s assume the same business but with the decreasing prices of the products as depicted in the following table.
We see that the price of the units consistently decreased.
Total music systems he sold = 200.
Let’s calculate the cost of the goods sold using FIFO.
Dan’s COGS calculation is:
50 units x $900 = $45,000
50 units x $900 = $45,000
50 units x $875 = $43,750
50 units x $875 = $43,750
Dan’s cost of goods sold = $177,500
Benefits of FIFO
So far in the article, we have discussed the concept of FIFO, its importance, and examples. This section introduces us to the various advantages of using the FIFO method.
- Widely Accepted and Used: FIFO’s worldwide acceptance is undeniable. Owing to its compliance with the IFRS makes it an internationally favorable method for application. Unlike LIFO which is used primarily in the US, FIFO finds approval across the globe.
- Logical and Easy to understand: FIFO method is easy to understand and convenient to apply for almost all organizations. With a cycle that runs from selling oldest to newest, this model works well for most businesses. Besides, the simple cash flow analysis makes it user-friendly.
- Negligible Manipulation: FIFO makes it difficult to manipulate the reported income in financial statements which is a great advantage.
- Cost-efficient and saves time: FIFO can help save a lot of time and money required to estimate the cost of the inventory being sold. This is because the cost directly depends on the foregoing cash flows of purchases that would be used first.
- Higher Gross Profit: The cost of goods sold (COGS) following the FIFO method is lower. This could impress the prospective investors as it depicts growth and profits in the future.
- Aligning costs with Inflation: With the newest inventory saved for sale in the future, the companies can bank on the potential opportunity to match costs in inflation. The newer stock can then be sold at higher prices, aligning with the times of inflation; giving the companies an edge to cope up with inflation.
- Avoids the risk of obsolescence: While using the FIFO method, businesses can rule out the chances of losses due to obsolete or expired products. The oldest stock cleared first, companies can gauge and create a recognizable flow of goods.
FIFO vs LIFO
In the earlier sections, we have seen that in FIFO, the oldest products are assumed to have been sold first and considers those production costs. However, LIFO- Last In First Out is the opposite of FIFO. It assumes the most recent products in the inventory are sold first and uses these costs.
The companies use these methods to estimate the inventory costs and how they will impact their profits. The profits will in turn attract the corresponding income tax.
These methods are assumptions and do not actually track the actual inventory. However, these assumptions assist the companies to calculate the COGS- Cost of Goods Sold.
Here’s a table that vividly compares values associated with the individual factors in FIFO and LIFO
From this table, we understand that LIFO is the exact opposite of FIFO.
Apple uses FIFO
While there are various methods of inventory management that Apple uses such as a sequential mechanism for efficient inventory tracking; it also uses the FIFO method. Following the FIFO model, Apple sells the units of its older models first. This ensures that before the launch of its newer models, the older stock would be cleared out. Its iPods, iPhones, headphones are managed through FIFO.
Adopting FIFO enables Apple to considerably reduce the aggregation of its old products in inventory.
Financial Impact: Apple uses the serialized stock technique which creates space for maximizing the proficiency of the goods that will follow in line. This also helps the brand introduce new stock consistently. These factors highlight its operational competency and remarkable stock administration.
Key takeaways
This piece brings forward essential points related to the FIFO method. Key takeaways are as mentioned:
- FIFO is a method of accounting that assumes that the goods purchased first will be sold first, and it assumes the cost of these goods sold first.
- FIFO is a widely accepted method across the globe, owing to its efficacy in raising profits.
- Although different companies use both FIFO and LIFO, FIFO has been considered better than LIFO due to its ability to enhance profitability.
- FIFO method has been adopted by some of the largest names like Apple Inc. as it trims the accumulation of the older stock and various other reasons.
