How FIFO inventory valuation method affects profitability?

FIFO – First in First out is one of the many different ways to value inventory for reporting purposes. It is one of different cost flow assumptions according to which inventory units that are received first by the entity will be the first ones to be sent to production hall for processing or consumption i.e. the oldest held unit will be the first to be applied for production.

The effect of FIFO inventory valuation method depends more on the circumstances surrounding the entity i.e. economic trend that entity is experiencing especially the price changes in a range of time for which profitability is assessed. Keeping things simple we can say that prices are either on increasing trend or decreasing trend. Both trends have different affects on the profitability of the business.

Before we discuss the situations specifically we must understand that valuation of closing stock has direct relation with gross profit of the business i.e. if value of closing stock increases gross profit will increase and on the other hand if closing inventory’s value reduces due to any reason (including valuation method used) then gross profit will also reduce. And due to the same reason entity’s seeking profits use such valuation technique that inflates the value of closing stock so that profits can also soar. One can understand it as limitation of accounting.

Coming to the point we recognized the fact that general economic trend can either have increasing prices trend or decreasing prices trend over particular length of time i.e. a month, a quarter or an year. If FIFO method of inventory valuation is used then in case of:

In case of rising prices i.e. inflationary trend, under FIFO inventory valuation method the inventory bought in the beginning of the period will be relatively cheaper as compared to inventory bought near the end of the period. As FIFO method assumes inventory first to be received will be the first to be applied in production therefore, cheaper material will be used in production. Because of this cost of production (or simply cost of sales) will decrease and relatively expensive material will be held as closing stock and thus value of closing stock will increase. Both factors will push the profits up and gross profits will appear to be more.

In period of decreasing prices i.e. deflationary trend, under FIFO method inventory bought in the beginning of the period will be relatively expensive than the inventory bought near the end of the period. As the latest inventory will be held as closing stock and the earlier inventory will be applied in production process this will push the cost of production (cost of sales) to increase and as closing stock is based on inventory bought at cheaper rate therefore, value of inventory held at year end will decrease. Increased cost of sales and decreased value of closing stock will cause the gross profit to decrease.

 

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