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First-In First-Out Method (FIFO Method):

1. Define and explain first in first out (FIFO) method.

2. How periodic and perpetual inventory systems impact this inventory valuation method.

Definition and Explanation:

The first in first out (FIFO) method assumes that goods are used in the order in which they are purchased. In other words, it assumes that the first goods purchased are the first used (in manufacturing concerns) or the first goods sold (in the merchandising concerns). The inventory remaining must therefore represent the most recent purchases.

Example:

Assume that a company had the following transactions in the first month of operations.

 Date Purchases Sold or Issued Balance March 2 2,000 @ \$4.00 2,000 units March 15 6,000 @ \$4.40 8,000 units March 19 4,000 units 4,000 units March 30 2,000 @ \$4.75 6,000 units

Periodic Inventory System:

Assume that the company uses the periodic inventory system (amount of inventory computed only at the end of the month). The cost of the ending inventory is computed by taking the cost of the most recent purchase and working back until all units in the inventory are accounted for. The ending inventory and cost of goods sold are determined as shown below:

 Date No. of Units Unit Cost Total cost March 30 2,000 \$4.75 \$9,500 March 15 4,000 \$4.40 17,600 6,000 27,100 Cost of goods available for sale \$43,900 Deduct: Ending inventory 27,100 Cost of goods sold \$16,800

Perpetual Inventory System:

If a perpetual inventory system in quantities and dollars is used, a cost figure is attached to each withdrawal. Then the cost of the 4,000 units removed on march 19 would be made up of the items purchased on March 2 and March 15. The inventory on a FIFO basis perpetual system for the company is shown below:
 Date Purchases Sold or Issued Balance March 2 (2,000 @ \$4.00)  \$8,000 (2,000 @ \$4.00) \$8,000 March 15 (6,000 @ \$4.40)   \$26,400 (2,000 @ \$4.00) (6,000 @ \$4.40) \$34,400 March 19 (2,000 @ \$4.00) (2,000 @ \$4.40) \$16,800 March 30 (2,000 @ \$4.75)  \$9,500 (4,000 @ \$4.40) (2,000 @ \$4.75) 27,100

The ending inventory in this situation is \$27,100, and the cost of goods sold is \$16,800 [(2,000 @ \$4.00) + (2,000 @ \$4.40)].

Notice that in these two FIFO examples, the cost of goods sold and ending inventory are the same. In all cases where first in first out method (FIFO Method) is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. This is true because the same costs will always be first in and, therefore, first out - whether cost of goods sold is computed as goods are sold throughout the period (the periodic system).

Objectives and Advantages of FIFO Method:

One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it does not permit manipulation of income because the enterprise is not free to pick a certain cost item to be charged to expense.

Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the fist goods in are the first goods out, the ending inventory amount will be composed of the most recent purchases. This is particularly true where the inventory turnover is rapid. This approach generally provides a reasonable approximation of replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.

The basic disadvantages of first in first out method (FIFO Method) are that costs are not matched against current revenues on the income statement. The oldest costs are charged against the more revenue, which can lead to distortion in gross profit and net income.

Relevant Articles:

 » » Difference between Perpetual and Periodic Inventory System » Basic Issues in Inventory Valuation » Average Cost Method » First In First Out (FIFO) Method » Last In First Out (LIFO) Method » LIFO Reserve » LIFO Liquidation » Basis for Selection of Inventory Method

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