First In First Out (FIFO) is one of widely known methods of cost assignment to determine the cost of units sold (cost of sales) and value of inventory still at hand by the period end.
FIFO assumes that entity use or consume units in the same order as they are purchased or produced i.e. the oldest goods purchased or produced are sold or consumed first and it is the newest goods that remains in the warehouse by the end of the end of the period.
The implication of FIFO assumption is that cost of goods sold includes the cost of oldest units purchased or produced whereas the value of period end inventory is based on the cost of newest units. In other words the value of closing inventory is considered to be better reflection of most recent market prices.
Getting in more details, with FIFO assumption in place:
- in period of rising prices the cost assigned to period end inventory will be higher than the cost assigned to units sold or consumed; whereas
- in period of falling prices the cost assigned to period end inventory will be lesser than the cost assigned to units sold or consumed.
1 FIFO under different inventory systems
We learnt that management may choose to record changes in inventory on periodic basis (intervals) or perpetual basis (regular). Though there are differences between periodic and perpetual inventory systems but under FIFO both systems will render same result. The reasons is that oldest costs are accounted for as cost of sales and latest cost is used to value inventory and recording is also done in the same fashion the oldest is recorded first and latest is recorded last. Lets understand this with an example
Example: FIFO under Periodic and Perpetual inventory systems
For the month ended details of inventory related transaction is provided.
[table id=5 /]
Calculate the Cost of Sales and Ending inventory value using FIFO method under:
(a) Periodic system
(b) Perpetual system
(a) FIFO Inventory valuation under Periodic system
Calculation of Units available for Sale:
[table id=6 /]
Physical count of inventory:
As we cannot count the inventory here so we are assuming it be same as we expect after all the transactions of purchases and sales and we can calculate the units:
= Units available for sale – Sales = Ending inventory
= 556 – (100+120+10+67)
= 556 – 297
Under FIFO method, our ending inventory will be from the latest purchases i.e. purchases of July 28 and 18 and thus valued as follows:
[table id=7 /]
Calculate of Cost of Goods sold:
Now that we know goods available for sale and ending inventory we can calculate cost of goods sold.
[table id=8 /]
(b) FIFO Inventory valuation under Perpetual system
Under perpetual system all changes inventory are recorded as they happen, therefore we have a chronological record of all the transactions and at the end of the period we automatically get the cost of goods sold and value of ending inventory.
[table id=9 /]
The total of units sold and their related cost is same as we calculated under periodic system above. Also the value of ending inventory is same. Hence, it confirms that choice of inventory system does not affect valuation of CGS and ending inventory under FIFO method.