Under the first-in-first-out method, the earliest costs (first costs) are assigned to the cost of goods sold, and the remaining costs (the more recent costs) are assigned to ending inventory.
The FIFO method assumes that the earliest-goods purchased are sold first. But in practice, it is not followed strictly, i.e., the earliest goods are sold first. Let’s see the solution to our problem table under FIFO method;
|Date||Units||Unit cost||Total cost ($)|
|900||Cost of Ending inventory||23,200|
The cost of ending inventory is $23,200, and the cost of goods sold is (48000-23200) $24,800.
Features of FIFO
- In the calculation of costs of Ending inventory, the more recent unit costs are assigned to the units not sold, those in ending inventory.
- In the calculation of the cost of goods sold, the earliest unit costs are assigned to units sold, those in the cost of goods sold expense.
Advantages of FIFO
- Simple to use.
- Yields are ending inventory amount on the balance sheet comprising more current costs than if the weighted average or LIFO is used.
- Usually produces a cost flow that approximates physical flow better than does weighted average or LIFO.
Disadvantages of FIFO
- It does not match recent costs with current revenue, as well as LIFO, does.
- Yields a higher taxable income than LIFO or weighted average during periods of rising prices.
Effects of the FIFO Inventory Cost Methods on Earnings During Inflation
Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year.
This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of the cost of goods sold among the three approaches, and the highest net income.
In an economy of rising prices (during inflation), it is common for beginning companies to use FIFO for reporting the value of merchandise to bolster their balance sheet.
As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company’s books.
Having a higher valued inventory and the lower cost of goods sold on the company’s financial statements may increase the chances of getting a loan.
However, as it prospers, the company may switch to UFO to reduce the amount of taxes it pays to the government. During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet.
On the other hand, FIFO increases net income (due to the age of the inventory being used in the cost of goods sold), and Increased net income can increase taxes owed.