When working on financial statements, you might have seen the term ‘FIFO’ before. So, what does FIFO stand for, and how is it used in accounting? Here’s a closer look at how to calculate FIFO.
What does FIFO stand for?
FIFO stands for ‘first in, first out.’ It’s an accounting method used when calculating the cost of goods sold (COGS). As the name suggests, FIFO works on the assumption that the oldest products are sold first. It helps work out the cost flow of goods, with the costs paid for the oldest products used first in the COGS calculations.
When calculating taxes, FIFO assumes that assets with the oldest costs are the assets included in the income statement’s COGS. Any remaining assets would be matched to those most recently purchased.
What is FIFO used for?
As we’ve mentioned above, the FIFO method can be used both in accounting, for working out the COGS, as well as for asset management or tax purposes.
During the manufacturing process, as products flow through the development stages to be sold as completed inventory items, their associated costs are recognised as expenses. Using FIFO, the cost of inventory produced first will be recognised first.
What is the difference between LIFO and FIFO?
As FIFO stands for ‘first in, first out,’ LIFO stands for ‘last in, first out.’ It’s primarily used in the United States, where businesses have a choice between LIFO and FIFO. Most other countries follow the IFRS (International Financial Reporting Standards) rules, which require the use of FIFO. Although LIFO is legal in the USA, FIFO is still often preferred because LIFO makes bookkeeping more complicated.
This is because – in using the LIFO method – a business states its most recent product costs before its older costs. However, the problem with this is that costs tend to rise over time. Although this reduces profit in the company’s financial statements, leading to lower corporate taxes, it makes the business look riskier to investors. Another issue with LIFO is that any non-perishable inventory value could be understated, staying on the book for longer.
How to calculate COGS using FIFO
Using FIFO to calculate COGS is relatively straightforward using the following equation:
COGS = Cost of Oldest Inventory x Amount of Inventory Sold
In this case, ‘inventory sold’ will refer to the cost of any purchased goods or produced goods, factoring in all associated labour, material, and overhead costs. It’s important to note that prices paid for inventory can fluctuate over time, so these will need to be taken into account as well. This can slightly complicate the COGS equation.
For example, if your business sells 50 units of a particular item, with 40 of these purchased at £5 per item and the remaining 10 purchased at £3 per item, you will need to reflect this in the equation:
COGS = (10 x £3 + 40 x £5) x 50 units
Advantages of FIFO
We’ve already touched on some of the problems with using LIFO, but here are a few more advantages of FIFO to consider:
FIFO is universally accepted according to IFRS regulations.
It follows inventory’s natural flow, with the oldest products sold first.
Following the FIFO method of clearing out the oldest inventory is less wasteful.
FIFO leads to higher profit recorded on financial statements, which is more attractive to investors.
Remaining inventory products offer a more accurate market value, reflecting current manufacturing costs.
Overall, using FIFO to calculate COGS gives a more accurate and less wasteful picture of a company’s finances, which is also helpful for future planning.
Disadvantages of FIFO
There are also some disadvantages to FIFO to keep in mind, though these pale in comparison to its advantages:
FIFO creates a wider gap between costs and profit compared to LIFO, resulting in higher income taxes.
Care must be taken not to overstate profit when using FIFO. You must factor in rises in product cost or manufacturing costs when calculating COGS.
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