FIFO, meaning “first-in, first-out” is a commonly used method to calculate the cost of goods sold, or in other words it’s an inventory costing method.
The principle upon which FIFO works is a rather simple one. The inventory (stock) first bought is sold out first. In business terms, the cost incurred by the company earliest for buying inventory is the cost expensed first.
FIFO is also referred to as cost flow assumption which is often used to remove costs from the inventory account when the inventory has been bought at fluctuating rates.
Implementation of FIFO: It is implemented by calculating the cost of the oldest inventory bought and will be eliminated when the first item of inventory will be sold. This will be reported in cost of goods sold and will be presented in the income statement of the company.
The principle FIFO also helps the business in many other ways. Few of them are as follows:
It helps in letting the business reimburse its costs of the inventory bought.
The stock first bought is likely to expire first too. So to avoid any losses for the company FIFO is used. The stocks first bought are sold out and then the cycle continues with the latest stocks sold last. Thus, at the end of the year what remains of inventory is what was bought last.
Moreover, FIFO also means that the cost of the current inventory bought will be shown in the inventory account and will make its way to the company’s annual, monthly or quarterly balance sheet.
Moreover, using FIFO, inventory assets that are reported in the balance sheet at the end of the year or quarter are reflective of recent purchases made by the company, thus depicting that the balance in the asset is close to the current replacement costs of the product.
When overall prices of products increase, and the business may have to make a shift in their pricing strategy, many businesses opt for First In First Out. The inventory bought by the company in June 2013 would be cheaper as compared to the one bought in June 2014. Hence, by selling the lot of inventory in 2014 they bought at a lower rate in 2013, the business would be making profit and thus saving up more on the cost of the product sold. However, some business delay raising prices and hold them constant until the batch bought earliest finishes. Therefore, the principle of FIFO is followed by a lot of businesses today to benefit the company as a whole.
