Full Form of FIFO
The Full Form of FIFO stands for First In, First Out. FIFO is a method of the costing, valuation and accounting method used for the valuation of the inventory in most purposes, indicates the method where the goods purchased first should be considered earlier in comparison to the goods purchased later for the calculation of the current value of inventory or achieving the cost of sales.
How Does it Work?
It is used in the costing method. When there are multiple items in the inventory which require to be allocated for particular products, the products which are purchased or bought earlier would be considered for the collection of the cost for the product. If it is being used for the calculation for the costing of the inventory, the first product used for the goods would be considered for the expense.
How to Calculate FIFO?
To calculate FIFO the price of the oldest inventory needs to be traced and then the cost prices of each unit are multiplied with the units of inventory sold. Then the amount arrived would be the price of the inventory and the remaining raw material units would be used for next inventory sales.
To arrive at the cost of sales, inventory plays a great part in it. An inventory constitutes multiple products or items or self-made goods of the company. So, let’s assume article A has been used raw material for product Y. The Y has 10000 pieces in the finished goods segments and within the production span, the company has bought X twice in a lot of 4000 pcs each. The first 7000 of X costed the Company at a rate of $10 each and the remaining 7000 has cost $12 each. So, for calculating the price of Y for the first 10000 units price of 10 would be considered for the first lot of 4000 pieces, and the remaining 6000 pieces would be priced at 12$ each.
There are various other methods of valuation except for FIFO such as LIFO and Weighted Average inventory method.
- LIFO is considered as last in first out. It is generally used in the inflationary economy due to an increase in the prices consistently. It helps in the price checking function of the goods and thus reflects a better inventory pricing and also keeps the profits in the check.
- Another widely used method apart from FIFO is Weighted Average. Weighted Average put weights on the prices of products when these are purchased. Also, In a way, it averages out the prices and removes the bias of earlier or later buys. This helps in providing the real picture of the profits and losses in the financial statements.
Difference Between FIFO and LIFO
- LIFO or Last In First Out is the opposite of FIFO or First in First Out. In LIFO the most recent inventory is used for calculation of the Cost of Goods Sold. This method could be used once the cost of inventory is rising over the period and most probably the cause is inflation.
- If the FIFO method would be used, the cost of goods sold would be comparatively lower to that of the current market prices and would reflect higher profit. To resolve the mismatch of prices, the LIFO method is used in such situations.
- In maximum industries, FIFO is used because there is no alarming situation where inflation is rising at a higher pace or the prices of the goods have suddenly shot up.
- In another situation, the FIFO works well because it shows the real cost position as used by the management. It is based on the principle that goods have a shelf life, and if the goods that arrived earlier would not be used, it would perish or lose their quality. So, to apply that in the costing world too, the FIFO method is used.
- It also helps to rule out products that came earlier than others to remove the possibility of the minimization of the wastage by taking goods arrived in the chronological order.
- Again, it is a simple idea and anybody with even a layman’s brain would be able to understand it. It is like deducting on a priority basis of arrival. It is widely used and thus removes the inconsistencies faced by using different methods.
- It removes the manipulation in the accounts as the records available would certify the costs received earlier. Again, most of the time, if the prices are increasing in the market, FIFO tends to increase the profit of the entity, as the goods arrived earlier must have been bought at a cheaper price.
Few disadvantages of the FIFO method is as follows:
- One of the biggest disadvantages of FIFO is that it tends to inflate the profits in a scenario of rising stock prices or a high inflation economy. As the prices are rising consistently, FIFO would calculate cost based on the earlier purchased product and that would not provide a fair picture in the financial statement.
- The idea seems easy to apply but sometimes due to the increased number of products used for preparing a product requires a lot of calculation and to arrive at the price of the earliest stock and to derive the first product, it becomes very clumsy and sometimes leads to clerical errors.
- It only works well if the prices of the goods remain in one zone or do not increase or decrease on multiple bases. It is also very difficult to get into an economy which provides exactly the similar prices for the products.
Though the FIFO has some disadvantages in the inflationary price movements, it still provides a lot to the valuation world because due to the simplicity, wide acceptance, and better presentation of the financial records, it poses a better valuation option in comparison to many methods. Also, it is being approved by various tax authorities across nations making it a suitable choice in selection policies of valuation.
This has been a guide to the Full Form of FIFO and its definition. Here we discuss how to calculate FIFO, its working, along with an example, advantages, and disadvantages. You may refer to the following articles to learn more about finance –