First In First Out Method of Cost Accounting

first in first out methodThe first in first out method, also known as FIFO, is a cost accounting term that explains the order in which inventory is sold, or the material flow. As the name implies, FIFO indicates that the business chooses to sell the goods that they received in their inventory first, before selling the goods they received last. This is the opposite of the method, LIFO, which is last in first out. FIFO is certainly the most popular method of inventory control as it seems more practical to get rid of older goods first, especially if they are perishable. To understand this business concept better (and others) check out Learn Accounting Principles.

When you go to the grocery store you’ll notice that there are expiration dates on a lot of the inventory. Milk, for instance, is a perishable good that needs to be sold before the “sell by” date is reached. Therefore, FIFO is applied and the milk that was purchased by the store first (the milk with the earlier expiration date) is pushed to the front of the fridge so customers will buy it before the newly purchased milk (with a later expiration date). If you reach behind the milk at the front of the shelf you’ll probably see milk with later expiration dates. This is just one example of FIFO at work.

Naturally, perishable goods should follow the FIFO method of accounting, it only makes sense to get rid of older – but still good – food before it spoils and the business has to write it off as damaged goods. So why would other companies employ the first in first out method of inventory flow? There are a few reasons: inflation, deflation and financial reporting.

Advantages of the First In First Out Method

  • Simplicity

FIFO is easy to use and understand. Plain and, well, simple.

  • Deflation

With deflation the costs of goods goes down, right? So when you already have a full inventory of goods bought at the inflated price and you sell these products your profit margin is not going to be as high as anticipated. This may not seem like a plus to FIFO, but it is because you can report fewer profits to the IRS which means you get to pay a smaller amount of taxes. Sounds good, right?

  • Inflation

On the flip side, if you are using FIFO and inflation occurs, the first items in were bought at cheaper prices, but because of inflation, you can now sell these goods at an inflated rate. This means your profit margin increases and that’s always a good thing. However, what this also means is because of your increased profits you are subject to paying more taxes when you remit payment to the government.

  • Financial Reporting

When you use FIFO you will be able to report all financial results in accordance with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The IFRS doesn’t even allow the last in first out method of material flow at all. Educate yourself on accounting and financial management so you know what’s what with everything finances.

Disadvantages

  • Clerical Error

With market prices of goods constantly in flux it can be hard to keep track of how to properly price the goods for sale. This goes hand in hand with what we discussed about deflation and inflation. Let’s say inflation occurs, the batch of products bought at the lower price now must be issued at market price – which in this case is higher. The prices now need to be changed in the ledger to represent the purchase price and the issue price and the margin of profit. Records need to be kept whenever the product price changes. With last in first out, the last batch of goods purchased is the first batch of goods being sold so the likelihood of a price change is low.

  • Price Changes

If the prices of the materials you’re purchasing change, you’re going to have to adjust your issuing price. This means that the costs you charge to your clients may end up varying greatly. When you have repeating customers this can be difficult because you may end up charging them more one time than you had previously – and vice versa.

Learning how to manage inventory, how to buy and sell your goods at competitive prices, how to properly record all financial transactions and understand depreciation can be easy if you know where to look. Try your hand at Introductory Financial Accounting.