First In First Out (FIFO) is one of the cost formulas that help cost assignment for inventory valuation. Entities can easily use FIFO with periodic or perpetual inventory systems.
In comparison to other inventory cost flow formulas and valuation methods, FIFO has advantages in some aspects but it is not without disadvantages in some situations.
1 Advantages of FIFO Valuation Method
- FIFO helps maintaining records of inventory in natural way i.e. recording is done in the same order as units are bought or produced therefore much easier to understand and relate.
- FIFO best fits the situation where entity holds inventory that has fast turnover and converts quickly thus revenue and costs are from related periods. This is also inline with matching principle of accounting. However, in some situations it can potentially misalign as discussed in disadvantages below.
- As ending inventory value is based on most recent purchases therefore, value is much better reflection of market prices of similar product prevailing at period end date.
- As oldest available units are accounted for under cost of goods sold, therefore, possible risk of reduced NRV and resulting loss recognition is negated automatically as entity is not dragging old units in inventory records.
- As the value of closing stock is pivotal in current asset total and related accounting ratios therefore, much relevant ending inventory value will lead to reliable analysis.
- Records each batch of inventory bought with respective cost thus management can ascertain inventories issued and held in warehouse are from which batch.
- Normally economies are inflationary meaning prices are always rising. Where inflation is causing increase in operating expenses, same inflation will also cause increase in ending inventory value which will help increase gross profit figure and ultimately covering the inflated operating expenses.
- Widely accepted by regulatory authorities and standards including IFRSs and GAAPs.
2 Disadvantages of FIFO Valuation Method
- It can get clumsy, complex and difficult to manage the inventory and respective prices of each batch if entity places many order for goods that have fluctuating price. Thus prone to more errors as well.
- As cost of goods sold is based on the oldest inventory based on prices that may no longer relevant for analysis conducted after the end of the period. Therefore, additional work might be needed to adjust for inflation and other factors affecting inventory price to get the suitable figure.
- For costing decisions, the cost of sales value is not reliable especially under inflationary economies. As cost of sales is based on prices at the beginning of the period that may be significantly different from prices at the end of the year. If entity is using cost plus pricing then chances are that price deduced on such cost is inappropriate (causing it to be much lower than what it should be) and not according to prevailing market price.
- The effect of inappropriate cost of sales figure is amplified if entity buys inventory in the beginning of the period for the whole period especially if prices fluctuate significantly. Thus forcing management to change procurement process and spread the purchases over the period to reduce the effect which may cause higher total ordering cost.
- Matching principle requires the revenue and costs to be matched and reported in the same period. Compliance may become difficult if the nature of product is such that it has slow turnover and require time to convert and price may change during this delay thus revenues and costs to be from different periods.
- Because of inflation, value of inventory may increase even if the physical count has decreased. This cause overstatement of profit or “bloating” with no real value to back up and renders profit comparison over the period and other analysis based on profit unreliable.