Good financial management isn’t just about keeping track of your company’s cash flow. It’s also about tracking the value of your non-liquid assets. Assets that are bought, acquired, sold, used, or disposed of are all included in a company’s valuation. The costs associated with these assets need to be properly accounted for in order to determine the profit associated with the sale of each asset.
Proper asset management ensures that business leaders can account for assets such as inventory, raw materials, equipment, machinery, and plant as they pass into and out of their companies. When preparing their income statement for tax purposes, business leaders will notice that the value of assets, when sold or disposed of, is less than when they were bought or acquired. The same items may also be purchased at different times throughout the year at varying prices due to inflation. As such, cost flow assumption needs to be incorporated into the company’s asset management.
One accounting method to aid in this is known as the First In First Out or FIFO method.
First In, First Out (FIFO) definition
First In First Out (FIFO) is an inventory valuation method whereby it is assumed that assets that the company buys, produces, or acquires first are also used, or disposed of first.
When preparing an income statement, FIFO assumes that inventory assets with the oldest costs (which may be lower prior to inflationary changes in inventory costs) are included in the Cost of Goods Sold (COGS). Any remaining assets are then matched to the assets that are most recently produced or bought by the company.
FIFO is useful for sectors like manufacturing, where materials move through different development stages, and are sold as finished items. At this point, the costs associated with inventory assets are recognized as expenses on the company’s balance sheet.
FIFO accounting assumes that the costs associated with inventory first purchased are also the first to be recognized. This causes the dollar value of total inventory to decrease since the inventory has been removed from the company’s ownership, and the FIFO system is used to calculate the costs associated with said inventory.
Under normal circumstances, the market value of assets rises in line with economic inflation, and FIFO accounting assigns the oldest costs to the COGS. These will theoretically be priced lower than more recently acquired inventory which is purchased at higher prices. Because these older expenses are lower, the result is a higher net income on the company’s financial statements. What’s more, since newly-acquired inventory is purchased at a higher price, this results in an inflation of the ending inventory balance.
Example of FIFO in practice
Now that we know how the FIFO inventory method works in theory, let’s look at it in practice.
Costs are assigned to inventory items as they are prepared for sale. These might include the purchase cost of raw materials, labor costs, and production costs. Under FIFO inventory management systems, costs are based on which items arrived first.
Let’s say that Company A purchased 100 items for $20 each. A few months later the company purchased 100 more of the same item for $25 each. Of these 200 items, the company sells 80. Under the FIFO method, the COGs for the 80 items sold is $20 per unit because the first items purchased were the first sold. First in, first out.
Of the remaining 120 items in inventory, the value of 20 items is $20 per unit while the value of 100 items is $25 per unit because they are assigned the most recent product costs. Once the original batch of 100 units is all sold, any remaining units will be valued at £25 each and this will be logged as the cost of goods sold.
Alternatives to FIFO
The FIFO method is inherently logical and in line with most business practices. Most businesses want to sell older inventory items first and hold onto newer items to avoid obsolescence, and items sold may have expiration dates because they are perishable. However, the inventory valuation method a company uses does not always follow the actual flow of inventory through the company.
Hence, FIFO is not the only calculation method used in asset management and inventory valuation. Let’s take a look at some of the other commonly used methods in corporate accounting.
Last In First Out (LIFO)
The LIFO method assumes that the last assets purchased by a company will be the first it sells, while older inventory is left over at the end of the accounting period. This is commonly used for companies that carry inventory that becomes obsolete very rapidly. It is also often used by companies with large inventories like car dealerships that can take advantage of lower taxes as prices rise and higher cash flows.
Assuming a normal inflationary economy, this will result in a deflation of net income costs and lower ending inventory balances in comparison to the FIFO system.
Specific inventory method
Specific inventory tracking can be employed when a company knows the value of all components that are attributable to a finished product. However, this involves a level of granular reporting that not all businesses and accounting software platforms can manage easily. Therefore, alternatives like FIFO and LIFO are appropriate to assume inventory costs.
Average cost method
When using the average cost inventory method, the same cost is assigned to every inventory item. An average cost calculation is achieved by dividing the cost of goods in inventory by the total number of items that are ready for sale. As a result, net income and ending inventory balances are usually somewhere between those for FIFO and LIFO.
Pros and cons of the FIFO method
As we can see, the FIFO system is not the only method used for inventory management and valuation. Nor is it necessarily the right one for your company. It’s essential to weigh the pros and cons of the FIFO method against other comparable methods like LIFO and the average cost method.
Let’s take a look:
Easy to understand and implement making it ideal for a nascent small business
Generally reflects the natural flow of inventory through a company
Company accounts accurately reflect the value of items held as unsold inventory are the newest
May be part of required accounting standards in some jurisdictions
Discrepancies between costs and revenue may artificially inflate gross profits
As a result, the company may pay more in income tax
FIFO is a logical and commonly used method of asset management and valuation. Now you know what it involves and its alternatives, you can weigh up the pros and cons to decide if it’s right for your business.