FIFO Method (First In First Out)
The FIFO technique is distinguished in that the oldest purchase costs are transferred to the cost of products sold, while the most recent costs remain in inventory.
We have lived in an inflationary economy for the previous 50 years, which implies that most prices have risen over time. When purchase costs rise the FIFO approach assigns lower older costs to the cost of goods sold and higher newer costs to products remaining in inventory.
By allocating lower costs to the cost of goods sold, FIFO often causes a firm to record somewhat larger profits than would be reported under the other inventory valuation techniques. Some businesses use the FIFO approach for financial reporting because they want to report the highest net income possible.
However, for income tax reasons, declaring more income than necessary leads to paying more taxes than necessary. Some accountants and business executives believe that FIFO overstates a company’s profitability.
Revenue is determined by current market circumstances. By balancing this income with a cost of goods sold based on previous (and lower) pricing, total profits may be continually overestimated.
The FIFO method has the conceptual benefit of valuing inventory at its most recent purchase cost. Therefore, this asset shows on the balance sheet at a value that is similar to its current replacement cost.
Characteristics of FIFO
- This is a popular approach for calculating the cost of goods sold and closing stock.
- The FIFO technique transfers the oldest available purchasing expenses to the cost of items sold. That implies the cost of goods sold will be cheaper, and the organization’s profitability will increase.
- The company’s current assets have the most recent appraised values since the current stock is valued at the most recent greatest prices.
ABC & Co. is a manufacturing firm. The following is the record of receipts and issues for the month of January 2020.
|200 Units @ $50/unit
|150 Units @ $75/unit
|100 Units @ $60/unit
|100 Units @ $50/unit
Calculate the value of the closing stock by the FIFO
Valuation of Stock by FIFO Method
FIFO Vs LIFO
The inventory management strategies FIFO and LIFO have many differences. They are comparable in one way: both rely on the product being constant, with the company’s cost base (its production cost or purchase price) being the only variable.
FIFO and LIFO have an effect on a company’s profitability. Here are the significant distinctions:
FIFO works best in businesses where product prices are stable and the company sells its oldest items first. This is because FIFO is predicated on the cost of the first products acquired, disregarding any price increases or decreases for later units.
Because FIFO leads to higher net income during periods of rising prices, it also results in increased income tax expenses.
But when we use the LIFO technique in a rising price period, it will result in lower net revenue. So, this technique will result in a lower tax expense.
Why Use FIFO over LIFO?
In the United States, a company can calculate its cost of goods sold using either the FIFO (“First-In, First-Out”) technique or the LIFO (“Last-In, First-Out”) approach. Both are lawful, however, the LIFO technique is frequently discouraged since bookkeeping is significantly more complicated and the system is easily manipulated.
Corporate taxes are lower for a firm that uses the LIFO approach because it allows the corporation to use the most current product costs first. These prices have often escalated over time. Reduced earnings may result in tax advantages, but it may also make a firm less appealing to investors.
The value of remaining inventory provided it is non-perishable, is likewise undervalued by the LIFO technique since the company uses earlier expenses to acquire or create those goods. That older inventory may, in fact, remain on the books indefinitely.
FIFO is valued by investors and financial institutions because it is a clear technique for determining the cost of goods sold. Because of its simplicity, it is also easier for management when it comes to bookkeeping.
Why is Inventory Valuation Important?
Inventory valuation can be time-consuming if done by hand, but it can be mostly automated with the correct POS system. Although choosing which approach to adopt may appear insignificant, the tiny variations between FIFO and LIFO inventory management can add up to hundreds of dollars (or even more for large businesses) in tax savings each year.
That is why it is critical to properly analyze your company’s inventory while finding and adopting the optimal inventory valuation technique to maximize your net profit each year and reduce your sales tax burden.
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