First in first out (FIFO)

The FIFO method, or First In, First Out, is a method of inventory management and valuation in which the goods purchased or produced first, go out first, i.e., in a way it could be considered that the oldest inventory is the one that is used or sold first. Thus, the accounting calculation and analysis is performed based on the cost paid for the oldest products.

A clear example and a sector where this method is widely used is the food sector with perishable products that have an expiration date. It is also very common in other sectors such as cosmetics, medicines or fashion, because these are sectors in which there is a risk that their products may become obsolete or go out of fashion.

This is the most widely used inventory valuation method worldwide, not least because it is easy for companies to understand and implement. As a result, declarations are more transparent and it is more difficult to manipulate company accounts with the aim of manipulating the company's finances.

In fact, this transparency provided by the use of the FIFO method means that in some countries it is mandatory for companies to use it to keep track of their inventory. Similarly, in other countries its use is not mandatory, but it is popular or recommended, among other things, because it is also less likely that a company using the FIFO accounting method will be examined by the tax authorities.

Why is inventory management and valuation important?

Inventory is one of the most important current assets that a company owns, since its form, quantity and value has a great influence on the company both internally and externally.

If the company were to run out of inventory, the vast majority of companies (depending on the business model they have and use) would suffer an interruption or complication in the sales or production process.

Likewise, in order to obtain these inventories, the company must assume important expenses, using its own capital or resorting to debt to be able to acquire them.

It is common for company inventories to have different values due to fluctuations in the costs of purchasing or producing inventories. For this reason, it is important to perform calculations to obtain the final value of the inventory through accounting methods, including the FIFO method.

Advantages and disadvantages of the FIFO method

Advantages:

• Easily understood method, universally adapted worldwide and perceived as a method that gives confidence.
• It is a method that facilitates the company's accounting as it follows the natural flow of inventory, resulting in less chance of errors.
• Less waste and products for disposal by the company, as the oldest stored products are the first to go.
• Financial statements are more complicated to manipulate, giving a very accurate picture of a company's finances both internally and externally.

Disadvantages:

• Using this method may result in a higher amount of income taxes to be paid by the company, due to the gap created between costs and revenues because of inflation.
• This possible exaggeration of the company's profit when using the FIFO method can also pose a problem internally on the part of the company, since business strategies and decisions could be made based on exaggerated profits if this possibility is not taken into account.

LIFO, the opposite method to FIFO

The opposite accounting method to FIFO is LIFO or Last in, First out, in which the last product purchased or produced is always the first out. This system is less used but is ideal for companies with non-perishable products that do not expire or lose value. This avoids having to move goods around in a warehouse, as the goods that came in last are usually easier to access.

This model also tends to result in lower taxes payable for companies in inflationary economies than if they used the FIFO method, as it allows companies to use their most recent costs first.

This reduction in profits can lead to tax reductions, but it can also make the company less attractive to investors.

The LIFO method, although legal, can be frowned upon because the accounting is much more complex and the method is easier to manipulate.

When to use and when not to use the FIFO method?

The FIFO method is a good option for business inventory accounting for:

• Companies that use a periodic inventory system: this type of system consists of calculating the number of inventory at the end of each period through a physical count. With the FIFO method, you could easily attribute expenses to inventory by looking at the most recent purchases.
• Companies that sell perishable goods: The FIFO method is ideal for this type of company because it significantly reduces the likelihood that their stocked products will expire, become obsolete and become unusable. In addition, the FIFO method would provide the most accurate inventory calculation.
• Companies involved in international business: in this case the use of the FIFO method becomes practically mandatory because it is one of the few inventory valuation method options allowed by the International Financial Accounting Standards (IFRS).

The FIFO method is not a good option for:

• Companies with unstable prices: although prices are practically never stable, in the event that this instability is above average it may be advisable to use another accounting method for inventory.
• Luxury or high value goods companies: these companies use a specific identification to follow the process and real cost of the product usually through serial numbers, which makes the use of the FIFO method really complicated.

In conclusion

The FIFO method is the most common and accepted method in the business and financial world to perform the accounting analysis of the inventory of companies. It is a simple method, easy to implement in a company and difficult to manipulate. Because of this, it is common that in some countries its use is mandatory in certain business sectors and conditions.

Despite its great advantages, it also has its disadvantages, such as the exaggeration of the company's profit due to the gap between expenses and income caused by inflation, which can result in the company having to pay higher taxes.

The method that each company uses for the preparation of its inventory accounting is subject to various nuances specific to each company, both externally and internally, so each company must evaluate which method is best suited to it, despite this, the FIFO method is still the most widely used worldwide.

References

Author: Alejandro Román