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 the 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 the FIFO method;
| Date | Units | Unit cost | Total cost ($) |
|---|---|---|---|
| 27 Nov | 800 | 26 | 20,800 |
| 8 Aug | 100 | 24 | 2,400 |
| 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 calculating Ending inventory costs, 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 amounts 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 the 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 a 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.
FIFO Method of Pricing Materials
This method assumes that the first unit making its way into inventory is the first sold. For example, let’s say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each and 200 more on Tuesday at $1.25 each.
FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).
Advantages :
- A simple method to understand and operate.
- Material cost represents the actual cost that should be charged to the product or process,
- Stock value is closer to the current price.
Disadvantages:
- This method will involve more calculations in fluctuating prices and too many purchases and issues.
- It overstates profit at a time of rising prices.
- If price changes frequently, comparison of one job with the other will not serve a useful purpose. Similar jobs will have different costs because of price changes,
- Adjustment for rejection and returns become complicated.
