Definition of First in First Out
FIFO or First-in-First-out denotes a method of evaluation for inventory, or other stocks in the accounting and valuation domain, reflects that if goods that have arrived first would be taken into consideration for the purpose of consumption, valuation, or calculation for cost of sales in relation to the goods that have added later in the inventory of the entity.
Explanation
Entities or organisations indulged in the manufacturing or production of goods need to report the ending inventory and the cost of sales for a particular product. The raw material used for the preparation could be purchased at intervals in the past at different prices. So, to calculate the overall cost price or the final product, different methods used to evaluate the raw material cost are FIFO, LIFO, and weighted average. So, the FIFO method stands for taking the inventory price that has been purchased earlier as a cost of the raw material. The same concept is applicable in the case of valuation of securities and other product as well.
How does it Work?
In the calculation for the costing of the final product, the quantity of raw material used for that particular product is being multiplied by the price of the raw material that arrived in the stock earlier. Later on, as the stock keeps getting exhausted, the price also changes in chronological order. Thus, the price of the goods is changed.
Example of First in First Out
For instance, XYC Corporation is engaged in the manufacturing of fountain pen sets. In one fountain pen, even though multiple products are being manufactured in-house, few items are being outsourced from various suppliers. Few different types of fountain pens are also outsourced from various suppliers. For a contractual order, one lot of the fountain pen has been received from a supplier for a price of $150. The quantity of the stock outsourced from that supplier is around 100 pens. Further, the supplier went out of business, and a similar pen is available from its peer for a price of $160 per pen. The company has manufactured 200 fountain pen sets which included the pens purchased from both the suppliers. Besides the purchased pen, other costs per box are $50. So, the price of the initial 100 boxes turns out the be $200 ( $150 + $50), and for the remaining pens, the cost would be $210 ($160+$50). So, once the primary stock is being consumed in total, the price of the boxes has risen due to the rise in the product cost. So, XYC corporation needs to sell the 101st and onwards pens at the price of $10 or more.
Uses of First in First Out
First in First out Method is very helpful in calculating the overall price of inventory and cost of goods sold. The FIFO method helps in understanding the true value of the product used in the production process. It is mainly helpful in the areas where it is important to know which inventory level was used primarily. Again, it is easy to track the part of the inventory If it is being produced in the batch, but otherwise, it turns out to be very difficult. So, to avoid the owners’ tracking the stock on a meticulous basis, the FIFO method helps the company keep the product flowing as fast as possible via ordering, storing, and sales.
FIFO vs LIFO
As FIFO stands for First In First Out, LIFO system stands for Last In First Out. In the Last in First Out method, the latest inventory arrived for the production is being used, and accordingly, the pricing is the latest one. It is generally used in the case of products where prices are rising continuously. So, to capture the rising prices, it is required to understand that the earliest stock should be taken into consideration. The recent rise in the price could also turn out to be inflation over a period of time. But in the case of LIFO, the price of the product is based on the earlier line of products, and generally, the price is quite lower, and resultantly, the overall profit turns out to be higher. So, if the current profit needs to be shown, then the LIFO method could be used. The main criteria behind the increased price are constantly rising inflation or the dearth of the requisite material.
Advantages of FIFO
Most industries or countries follow the FIFO method because there is no such situation that demands the application of the LIFO method. If the prices are not rising on an incessant basis, the FIFO method could easily be used. The FIFO method states that every product has a shelf life, and it should be used in order of the arrival of the goods, and in this manner, the quality of the product gets retained. Also, chronologically using the goods helps in removing the wastage or spoilage, unlike the LIFO method. Further, the FIFO method is very easy to understand and apply, and even a simple businessman would be able to understand it with ease. As this method is popular, it becomes very easy to correlate the two companies for the cost structure. Sometimes, it also helps in the removal of excessive pries charged at a later time.
Disadvantages of FIFO
As FIFO takes into consideration stock that has come earlier in the business, the profit tends to get higher. Also, sometimes the stock is quite old, and the valuation based on that does not reflect the true picture. It also involves keeping into account the calculation related to all the stocks and to provide on a consistent basis.
Conclusion
Overall, despite a few minimal shortcomings in the inflationary price movements, FIFO helps in providing the valuation of the stock an easy process because of wider acceptance, simplicity, and better presentation of the method. It turns out to be one of the best methods out of the LIFO and Weighted Average method.
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