Inventory valuation methods and cost flow assumptions are important when it comes to inventory management and control systems. Among these methods is the First In, First Out (FIFO) Inventory Method.
In this post, we will explore the definition and purpose of the FIFO Inventory Method, how it works, its advantages and disadvantages, and its impact on the inventory turnover ratio.
The First In, First Out (FIFO) Inventory Method is a cost flow assumption used in inventory management. It assumes that the first items purchased or produced are the first ones sold or used. This means that the oldest costs are matched against revenue first, while the newest costs remain in inventory.
Under FIFO inventory method, inventory costs are determined by assuming that all goods received are sold in the order they were acquired. In other words, goods purchased or produced first (oldest) are sold or used first as well.
For example, if a company purchases 10 units of a product for $1 each on January 1st and later purchases another 10 units for $2 each on January 15th, then sells 5 units on January 20th, it will assume that it sold the first 5 units purchased for $1 each.
One of the main advantages of using FIFO Inventory Method is that it results in lower taxable income during periods of inflation since newer and higher-priced items remain in inventory. Additionally, with an accurate valuation calculation using FIFO method, businesses can make informed decisions about future purchases by identifying which products have been sitting on shelves longer than others.
While FIFO method provides benefits to businesses during inflationary periods by reducing taxable income and helping them make informed decisions about future inventory purchases; however, there is a disadvantage to using FIFO inventory method during deflationary periods. In this scenario, the cost of goods sold may exceed the selling price because the cost of earlier purchases are higher than current replacement costs.
The FIFO Inventory Method has a significant impact on the inventory turnover ratio. The reason being that it assumes that older inventory is sold first, which means that newer items remain in stock. This results in a lower cost of goods sold and hence a higher gross profit margin.
FIFO and LIFO (Last In, First Out) are both inventory valuation methods that companies use to manage their inventory costs. While FIFO assumes that the oldest costs are matched against revenue first, LIFO assumes that the newest costs are matched against revenue first.
Industries that produce perishable goods like food, cosmetics or pharmaceuticals benefit most from using FIFO Inventory method because older products have lesser shelf life and hence can't be stored for long periods. Therefore, using FIFO helps these industries track their inventory levels more accurately.
