The first thing we need to establish, is that inventory costs a certain amount to purchase or produce, but that price might not be the one assigned to the inventory when it comes time to value it. This is because it is hard to identify every individual item based on its purchase price. How we get around this, is using a method of assuming the value of inventory. We allocate lots of inventory a monetary value entitled cost of goods sold, based on the time point at which they were purchased or produced.
There are two methods of assigning inventory values, which are assumption-based, and one method that considers the purchase or production cost of all inventory and computes a weighted average. It is vital to research all the methods and decide which one would be best for your company to adopt, as your choice will play a huge role in your balance sheet. In this article, we will look at FIFO.
Basics of FIFO
FIFO or ‘First-In- First-Out’ reflects a common logic that the oldest of something will be used first thereby maximizing the item’s ‘optimum’ period. This is because the general rule of thumb is that things deteriorate and become inferior as they age. This method is particularly useful for any company in the food and beverage or pharmaceutical industries for example where products have a shelf life associated to them beyond which, they are no longer usable and essentially have no value. This means, that the company has an optimum timeframe for sales where the product represents the most value to the customer regarding shelf life and preservation. In this instance goods are likely to be sold on the premise that they were the items that were purchased or produced first, and the accounting books will reflect this on paper with the first receipted goods being recorded as sold first and representing the lowest cost of goods sold (COGS). This is with the assumption that the company is operating in a standard economy with inflation.
Let’s look at how this works in an equation. The basic and fundamental equation to calculate the value of stored inventory is this:
(Inventory at the start + Purchases) – COGS = Final inventory
Using this equation in two working examples we can show what the effect of FIFO is and what the effect of the other valuation method called LIFO (Last-In- First-Out) is. FIFO assumes that the earliest receipted goods are the cheapest ones (due to inflation for example) and these are also assumed to be the goods sold first. Therefore, as per the above equation, the lesser the COGS, the greater the value of the final inventory.
Conversely, FIFO assumes that the most recent purchased or produced goods are the most expensive ones and are also assumed to be the goods sold first. Again, if we put this into the equation, it is clear that with a greater COGS, we get a smaller final inventory value.
What FIFO means for you
So, what are the consequences of these two methods? With LIFO, on paper it appears as if the final inventory value and final profit are less because of the relatively high value assigned to COGS. The effect of this reduced profit is the requirement to pay less tax, which of course can be desirable for the company. However, a point worth noting here is that many countries have outlawed the use of LIFO as the tax obligation is less, meaning it is not in the best interest of governments.
On the other hand, with FIFO, the COGS is assigned a lesser value as the stock is older, therefore the final inventory value is greater, as are the profits. Ordinarily this would be the business goal and be very welcome indeed, however a greater profit presents with the requirement to pay more tax as it is income-weighted. Due to this, many people will choose to adopt the LIFO method for its less significant tax obligation.
Regardless of which method you choose to use to value your inventory, you need to know how it works, which governing bodies will tolerate it and what effect it will have on your company’s financial success.