First in First out is a method used in inventory valuation for accounting purposes. The method advocates the practice of using the oldest inventory item first, hence the name "first in" "first out." The principle is also applicable in maintaining precise sequence during and through the production of items because it ensures that the first part into a process or inventory location is also the first part to be used. The FIFO lane is one method of controlling and regulating a pull system that is between two disconnected (decoupled) processes.
While you may think of the movement of physical inventory when you hear the phrase first in first out, this is not always true in terms of inventory valuation at an aggregate accounting level. In fact, when looking at valuation using the FIFO method one must assume that the oldest inventory is used first. What does this mean exactly? Well, assets that are produced or acquired first are sold, used, or disposed of first. With that being said, there is no direct relationship between the movement of physical assets and the valuation other than the fact that accounting assumes the oldest is used first. When looking at FIFO from a tax perspective, the method assumes that inventory with the oldest costs are shown on an income statement under the cost of goods sold. Any other inventory that is left over is paired with the most recent purchase price or production cost.
Why would an organization use FIFO?
Remember, always speak with your accountant or CPA before deciding on a valuation method. In most organizations as inventory progresses to later stages of transformation and as finished goods are removed from inventory and sold, the costs associated with that item should be acknowledged as an expense. However, in the case of FIFO, it is assumed that the cost of the oldest inventory will be recognized first. This lowers the total value of your inventory. With this in mind, there are many advantages and disadvantages of the FIFO method.
One advantage is that when inflation occurs, or prices are rising, the FIFO method reduces the impact of inflation or understates the value of your inventory. Of course, this also means that if prices are falling or deflation is occurring FIFO overstates the value of your inventory. This occurs because of the cost of the oldest items in your inventory. For example, during inflation the cost of purchasing newer inventory will be higher than the cost of older inventory. Another benefit is that FIFO is probably the most used form of valuation across the global environment. One of the last benefits of First in First Out Valuation is that it is a good method for reducing obsolescence of inventory because the oldest is used first. Now let’s turn our attention to the disadvantages of FIFO.
Disadvantages of FIFO
To do this we will quote from an article on Investopedia entitled What Are the Disadvantages of the FIFO Accounting Method? In the article, the author, Greg Depersio cites two key disadvantages. The First according to the article is that FIFO “tends to overstate gross margin, particularly during periods of high inflation, which creates misleading financial statements. Costs seem lower than they actually are, and gains seem higher than they actually are.” The Second disadvantage according to the article is that because of “these high paper profits” a company may “incur substantially higher income taxes.”
Example of FIFO
Subscribe below and receive lean, six sigma, operations, supply chain, logistics, distribution and business terms in your mailbox.
CLICK HERE TO SUBSCRIBE