FIFO, or first in, first out, is a method of inventory valuation that assumes the first items purchased are the first sold. This method is widely used by companies as it matches the actual flow of goods, reducing the risk of inventory loss and obsolescence.
FIFO is preferred by companies that want to impress investors as it results in higher pre-tax profits due to a lower unit cost. However, it also leads to a higher tax liability. The method is commonly used to calculate the cost associated with inventory and minimize the risk of obsolescence.
In an inflationary market, FIFO can provide an added advantage. It results in higher gross profits, lower costs of goods sold, and a higher value of ending inventory. The method allows companies to have more expensive items left in stock, which can be sold for a higher price in the future.
FAQs
When should a company use FIFO?
FIFO is best suited for companies that want to reduce the risk of inventory loss and obsolescence or need to impress investors. It is also useful in an inflationary market.
What is the disadvantage of using FIFO?
The main disadvantage of using FIFO is the higher tax liability that comes with reporting higher pre-tax profits due to lower unit costs.
How does FIFO work in an inflationary market?
FIFO results in a higher value of ending inventory, lower cost of goods sold, and higher gross profit during inflation. This is because the more expensive items remain in stock when FIFO is used, which can be sold for a higher price in the future.
Final Thoughts
While the FIFO method has its advantages and disadvantages, it remains one of the most theoretically correct methods of inventory valuation. Companies should choose the inventory valuation method that best suits their business needs and goals.
