Updated July 14, 2023
Definition of First in First Out
FIFO or First-in-First-out denotes a method of evaluation for inventory or other stocks in the accounting and valuation domain, reflects that if goods that have arrived first would take into consideration for the purpose of consumption, valuation, or calculation for cost of sales in relation to the goods that have added later in the inventory of the entity.
Explanation
Entities or organizations indulged in the manufacturing or producing goods need to report the ending inventory and the cost of sales for a particular product. The raw material used for the preparation could be purchased at past intervals at different prices. So, to calculate the overall cost price or the final product, different methods used to evaluate the raw material cost are FIFO, LIFO, and weighted average. So, the FIFO method takes the inventory price purchased earlier as a raw material cost. The same concept is applicable in the case of the valuation of securities and other products as well.
How Does it Work?
In calculating the cost of the final product, we multiply the quantity of raw material used for that specific product by the price of the raw material that arrived in the stock earlier. Later, as the stock keeps getting exhausted, the price changes chronologically. Thus, the price of the goods is changed.
Example of First in First Out
For instance, XYC Corporation is engaged in the manufacturing of fountain pen sets. In one fountain pen, even though multiple products are manufactured in-house, few items are outsourced from various suppliers. A few different types of fountain pens outsource from various suppliers. For a contractual order, one lot of the fountain pen has been received from a supplier for $150. The quantity of the stock outsourced from that supplier is around 100 pens.
Further, the supplier went out of business, and a similar pen is available from its peer for $160 per pen. The company has manufactured 200 fountain pen sets, including the pens purchased from both suppliers. Besides the purchased pen, other costs per box are $50. So, the price of the initial 100 boxes turns out the be $200 ( $150 + $50), and for the remaining pens, the cost would be $210 ($160+$50). So, once the primary stock is consumed in total, the price of the boxes has risen due to the rise in the product cost. So, XYC corporation needs to sell the 101st and onwards pens for $10 or more.
Uses of First In, First Out
The first in, First out Method is very helpful in calculating the overall price of inventory and cost of goods sold. The FIFO method helps understand the product’s true value in production. It is mainly helpful when it is important to know which inventory level was used primarily. Again, tracking the part of the inventory is easy if it is being produced in the batch, but otherwise, it turns out to be very difficult. So, to avoid the owners’ tracking the stock meticulously, the FIFO method helps the company keep the product flowing as fast as possible via ordering, storing, and sales.
FIFO vs LIFO
As FIFO stands for First In First Out, LIFO system stands for Last In First Out. In the Last in First Out method, the latest inventory that arrives for production is being used, and accordingly, the pricing is the latest one. It generally uses in the case of products where prices are rising continuously. So, to capture the rising prices, it is necessary to understand that the earliest stock should be considered. The recent rise in the price could also turn out to be inflation over a period of time. But in the case of LIFO, the price of the product is based on the earlier line of products, and generally, the price is quite lower, and resultantly, the overall profit turns out to be higher. So, if the current profit needs to be shown, then the LIFO method could use. The main criteria behind the increase in price are constantly rising inflation or the dearth of the requisite material.
Advantages of FIFO
Most industries or countries follow the FIFO method because no such situation demands applying the LIFO method. If the prices are not rising incessantly, the FIFO method could easily be used. The FIFO method states that every product has a shelf life, and it should be used in order of the arrival of the goods, and in this manner, the quality of the product gets retained. Also, chronologically using the goods helps remove the wastage or spoilage, unlike the LIFO method. Further, the FIFO method is very easy to understand and apply, and even a simple businessman can easily understand it. As this method is popular, it becomes very easy to correlate the two companies for the cost structure. Sometimes, it also helps in the removal of excessive prices charged at a later time.
Disadvantages of FIFO
As FIFO considers stock that has come earlier in the business, the profit tends to increase. Also, sometimes the stock is old, and the valuation does not reflect the true picture. It also involves considering the calculation related to all the stocks and providing consistently.
Conclusion
Despite a few minimal shortcomings in the inflationary price movements, FIFO helps provide the stock’s valuation an easy process because of wider acceptance, simplicity, and better presentation of the method. It is one of the best methods out of the LIFO and Weighted Average methods.
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