If you are searching for jobs in accounting that involve inventory or asset management, you may come across the term “FIFO.” Employers may want their bookkeepers and accountants to know the FIFO method and apply it in their work. It’s essential to learn what FIFO is in accounting and understand its functionality, so you can apply your knowledge in interviews and beyond.
We will cover what is the FIFO accounting method, its benefits, and how it compares to other systems, so you can gain a better understanding of the concept by the end of this article.
What is FIFO, and what does FIFO mean in accounting?
In accounting, FIFO stands for “First In, First Out.” It is an accounting method used for managing and valuing assets that details of which assets purchased or acquired are sold, used, or disposed of first. A simpler way to describe this method is that it assumes the first items placed into inventory will be the first ones to go out, and it is up to bookkeepers to oversee this process for an organization.
An example of what is the FIFO accounting method is if an organization were to order 50 items priced at $10 and then order 50 more items priced at $20. The first 50 items to be sold will be resold at $10. This is because the first items were priced at $10, and according to the FIFO method are the first to go out to consumers.
As an accountant, you will notice the remaining items in inventory are accounted for at the most recently incurred costs. The inventory asset recorded on the balance sheet details costs close to the most recent costs that could be obtained in the marketplace.
How is FIFO different from other methods?
The most common alternative method to FIFO is the LIFO method, meaning “Last In, First Out.” The LIFO method is the opposite of FIFO because it assumes the last products to enter inventory will move out first.
Let’s use this method as an example. Let’s say you are hired on as the bookkeeper of a manufacturing company. The value of your inventory would be based on the cost to produce the engines your organization made yesterday versus the cost to build the engines they made last month. By the way, the use of LIFO is banned under IFRS.
Another valuation method example includes Average Cost Inventory. With this method, the same cost is applied to each item. The average cost is calculated by dividing the cost of goods in inventory by the total number of items available for sale. This results in net income and ending inventory balances between FIFO and LIFO.
Specific Inventory Tracing is another valuation method and is used when all components attributable to a finished product are known. If not all pieces are known, then any of the above methods can work in their place.
While all of these methods are acceptable alternatives to the FIFO method, the FIFO method is highly respected and accepted all over the globe.
Why does the inventory valuation method you choose matter to your business?
The inventory valuation method you choose matters because it gives your organization operation definitions for several business-related factors. The data you derive from an inventory valuation method provides your business with actionable steps to make strategic decisions.
The manner how an organization determines its inventory’s value, determines how much profit they believe the company makes, which ultimately affects how much is paid in income tax. The Internal Revenue Service (IRS) grants businesses the opportunity to deduct the cost of inventory from their taxable income. The lower your company’s profit is, the lower the amount in taxes it has to pay. As an accountant and bookkeeper, it’s important to choose the method that benefits the business during tax season.
It’s critical to choose the correct inventory valuation method because it has a direct impact on a company’s profit margin. The method you choose can lead to drastic differences in the cost of goods sold, net income, and ending inventory. Making the right inventory valuation choice should be an organization’s top priority.
When is FIFO better than other inventory valuation methods?
FIFO is a widely used method of valuing inventory all over the world. It is known to be the most accurate method of aligning the expected cost flow with the actual flow of goods, offering businesses a clear picture of inventory costs. It’s also easier to understand and manage versus the other methods. Moreover, most organizations prefer to move their oldest products first before the newer products.
The FIFO method is accepted under the Generally Accepted Accounting Principles and International Financial Reporting Standards. As a bookkeeper and accountant, knowing the FIFO accounting method is critical.
The FIFO accounting method also reduces the impact of inflation, assuming the cost of the older inventory is less than the cost of the newer inventory. It also reduces the obsolescence of inventory. The FIFO accounting method generates more reliable financial statements because it’s more difficult to manipulate the numbers compared to other valuation methods.
What are the advantages of the FIFO accounting method?
There are many reasons why businesses prefer to use the FIFO method when calculating inventory valuation, and these include:
- Easy-to-use method. The FIFO method is easy for bookkeepers and accountants to understand and is a well-respected and accepted method globally.
- Creates less waste. Since companies are moving out older items first, they are creating less waste.
- Follows natural flow of inventory. Since older products go out first, it’s easier for bookkeepers to keep track of what’s going out to consumers. As opposed to the scenario of the newer products going before the old.
- Higher profit to be gained. Since FIFO allows you to subtract the cost of your oldest (and least expensive) inventory, your gross income is higher.
- The products remaining in inventory will better reflect market value because the products are newer and have been built more recently, meaning they are more up-to-date and with consumer standards.
How do you calculate FIFO?
To calculate FIFO, you first have to calculate the cost of goods sold (otherwise known as COGS). Using the FIFO method, determine the cost of your oldest inventory first before the newest. Multiply that cost by the amount of inventory sold. The inventory sold refers to the cost of purchased goods or the cost of produced goods. It’s important to note that even though a company pays a price for its inventory, prices often fluctuate. Fluctuating costs need to be taken into account when calculating inventory valuation.
Learn More about What is FIFO in Accounting
The FIFO accounting method is one of the most effective inventory valuation methods to date. At TaxDome, we empower accounting firms with powerful workspaces that allow you to create seamless workflows. If you want to learn more about what is FIFO in accounting, then visit our blog to stay informed.