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

Learning objectives of this article:

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

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

  3. 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:

Classification of Inventory

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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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Variable Costing System
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  Activity Based Costing System
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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