First-In First-Out Method (FIFO
Method):
Learning objectives of this article:
-
Define and explain first in first out (FIFO)
method.
-
How periodic and perpetual inventory systems
impact this inventory valuation method.
-
What are advantages and disadvantages of FIFO
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. Disadvantages of
FIFO Method:
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:
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