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First In, First Out (FIFO): Definition, and How it Works          

First In, First Out (FIFO): Definition, and How it Works

First In, First Out (FIFO): Definition, and How it Works

First In, First Out (FIFO) is an inventory valuation method in which assets produced or acquired first are sold first. FIFO follows the hypothesis that the sale or usage of goods follows the same order in which they are produced/acquired. The other name for FIFO is last in still here (LISH). The inventory on the balance sheet corresponds to the most recently bought inventory when using the FIFO methodology. Businesses are much more likely to sell the oldest produced/purchased goods first, so FIFO most closely resembles the flow of inventory.

The FIFO method of inventory management is generally used by companies dealing with perishable goods like supermarkets. They use the FIFO method for managing inventory so that the first produced goods are sold first. This helps companies to sell goods with earlier expiration dates before the goods have later expiration dates.

Another example of FIFO could be seen in restaurants and homes for managing food. There is also an alternative for the FIFO method, which is the last in first out (LIFO) method. Both methods use a different approach, but this does not restrict a company to use only a single method. The company, for example, can use the LIFO system for accounting purposes and FIFO for inventory management. 

Most businesses prefer to sell old goods first as the oldest products are the ones most likely to lose value due to long-term storage. The unsold goods are also the newest ones, this also indicates that the company’s financial statements will more accurately depict the value of the current inventory. 

What is First In, First Out (FIFO)?

First In, First Out also known as FIFO is an inventory valuation system, under which the first produced/purchased products are sold first. First In, First Out (FIFO) is a globally accepted inventory and asset valuation method as the assumptions used by this method perfectly match most companies.

The FIFO method is considered the most effective method both theoretically and logically because when first produced/purchased goods are sold first, it reduces the chances of inventory obsolescence. Obsolete inventory includes items in stock that can no longer be used. 

This method is more effective when the price is falling because the cost of issuing goods will be high and the cost of replacing materials will be low. However, during inflation, this method will not work efficiently because the cost of replacing the materials will be high even though the issue price of the materials used in production will be low.

How does First In, First Out (FIFO) work?

First In, First Out (FIFO) works on the concept of selling the older inventory items first. In First In, First Out (FIFO), the cost incurred first is the cost related to the inventory that was purchased first.

How does First In, First Out (FIFO) work
How does First In, First Out (FIFO) work

For example, a company reported starting inventories of initial 200 units at ₹5/unit. The company makes further purchases as:

  • 200 units at ₹10/unit
  • 200 units at ₹15/unit
  • 200 units at ₹20/unit

Suppose the company sells around 500 pieces. The cost of goods sold (COGS) will be equal to ₹4500 (200*5 + 200*10 + 100*15). The COGS is calculated taking into consideration the price per unit from the beginning until the total number of units is fulfilled.

The cost of remaining inventory is calculated similarly by multiplying the units left with the price per unit. The cost of the remaining inventory for the above case will be ₹4500 (100*15 + 200*20). 

How to sell stock using the First in, First Out (FIFO) method in the Stock Market?

The first in, first out (FIFO) method of the stock exchange, works on the principle of selling the earliest bought shares first. First in, First Out (FIFO) is the pre-set method used by brokers to sell stocks. The investor can use both FIFO as well as LIFO methods for trading stocks in the stock market. Both of these approaches are different and the tax deductions would be different because of this.

The key advantage of the first in, first out method is that the investors are more apt to earn long-term capital gains treatment for any earnings they make by using the shares they had bought first. But the FIFO method for the stock market also has one disadvantage.

During a price rise, the stock bought by the investor earliest will have the lowest cost basis. The default method of the stock exchange is generally first in, first out (FIFO). In case the investor wants to change the method, written confirmation from the broker is required. 

It is, therefore, important to consider the tax benefit while selling a stock. An investor or a trader should ask their broker to give them details when using either of the methods. The FIFO method will usually have a lesser tax benefit since the amount garnered over a large period of time will have more taxable gains in it. The LIFO method, on the other hand, will only have a smaller taxable element in it. 

How does First In, First Out (FIFO) differ from other Inventory Valuation Methods?

The method of First In, First Out (FIFO)  differs largely from the other two methods of inventory valuation. There are three inventory valuation methods used globally: First in, first out (FIFO), Last in, first out (LIFO) and Weighted Average cost.

FIFO works on the principle of selling the earliest produced goods first. The FIFO method is generally used by food processing plants, supermarkets etc because this method works on selling the goods before they expire. 

LIFO stands for last in, first out. The LIFO method works on the principle of selling the most recently produced goods first. This method is generally used in the United States of America. In an inflationary market, LIFO results in a lower inventory balance as compared to first in first out methodology.

The average cost inventory approach gives every item in the inventory the same cost. The average cost method is calculated by dividing the overall number of products that are available for sale by the cost of goods in inventory. Net revenue and ending inventory levels are in between FIFO and LIFO.

What are the advantages of First In, First Out (FIFO)?

The First In, First Out (FIFO) method is considered the most logically effective method for inventory valuation. They have many advantages and five of them are as follows. 

  1. Easy to understand: FIFO is a method that can be easily understood by even the most basic-level managers. The concept is simple enough to follow and easy to understand. 
  2. Globally Acknowledged: This is a method that is accepted worldwide and therefore, will not be a problem for managers to take up or implement the process in a new environment or organization. 
  3. Prevents manipulation: FIFO method is a very transparent and consistent method that helps in preventing manipulations in sales and sales figures. The values and formula used to calculate the sales report are exact and won’t change with time in the FIFO method. 
  4. Saves revenue: There will be no loss in sales revenue if the organization follows the proper procedures of the FIFO method. 
  5. Proper inventory: The FIFO method would enable the manager to maintain a record of proper inventory of stocks and products. 

The First in, First out method is widely used in many organizations across the globe and it has proved time and again to be efficient. Taking up this method would only act as a helping hand to have seamless inventory calculation. 

What are the disadvantages of First In, First Out (FIFO)?

The FIFO system, like any other system, has its own drawbacks in inflationary markets. The following are the four major disadvantages of the FIFO system.

  1. Higher Taxes: Companies following FIFO for accounting purposes, usually pay higher taxes. This is because the products that have been stocked with the company for a long time incur more tax liabilities. 
  2. Inflation: Price inflation can cause the inventory valuations to change and it can be a tedious process to change the value multiple times. It can also cause errors in the calculations of revenue statements.  
  3. Price fluctuation: Inflation isn’t the only way the prices of goods can change. External factors like foreign policies and changes in import and export duties or changes in supply and demand can affect prices to fluctuate. These can also cause errors in the valuation of the stock inventory. 
  4. Large data: The FIFO method involves the usage of a large collection of data. It can sometimes be a lot and therefore can cause clerical errors. 

The FIFO system, as a standalone method, is considered good and effective to meet its purpose. There can be many external elements however, that can disrupt the smooth processes. It is therefore imperative to understand those external factors and make contingency plans wherever necessary. 

What are the examples of First In, First Out (FIFO)?

The method of First In, First Out (FIFO) works on cost flow assumption purposes. FIFO assigns the value of the oldest produced goods in cost of goods sold (COGS). For evaluating the value of remaining inventory, the FIFO system uses the price of recently produced goods.

For example, A pen manufacturing company produces pens with the following prices.

  • 1000 Shirts at ₹10/unit
  • 2000 Shirts at ₹11/unit
  • 2500 Shirts at ₹22/unit

(Suppose 3500 pens are sold)

Cost of goods sold (1000*₹10 + 2000*₹11 + 500*₹22) = ₹ 43,000

Remaining inventory (2000* ₹22)= ₹ 44,000

Companies are generally inclined towards FIFO because this eliminates the chance of obsolete inventory.

What type of Companies use First In, First Out (FIFO)?

FIFO is considered as theoretically logically the most effective inventory valuation method for perishable goods. FIFO helps industries to sell the products produced earliest first to avoid obsolete inventory. This ultimately helps to increase the profit margin and reduce cost of products.

Food processing plants work on the principle of FIFO. The products produced by food processing plants have a limited shelf life. The companies have to sell the products before they expire, to make the business profitable. Logically the best way of achieving this is by selling the earliest processed food first. Using FIFO methodology, unnecessary wastage of food is also reduced, which reduces labor cost.

Similarly, the first in first out concept is also used by supermarkets for selling milk products. Stockers move the oldest merchandise to the front as customers purchase milk and place fresher milk behind those containers. First sold are milk cartons with the earliest expiration dates, followed by milk cartons with later expiration dates. FIFO procedure makes sure that outdated products are sold before they expire or become unusable, preventing lost revenue.

The fashion industry is very dynamic and the biggest problem that it faces is dead stock. Dead stock is the unused inventory that no one is interested in buying. So to maintain profitability fashion industries also use the principle of FIFO, under which the goods follow the same order in which they are produced. FIFO reduces the quantity of dead stocks, which ultimately reduces storage costs and helps companies to maintain profitability.

What is the difference between First In, First Out (FIFO) and Last In, First Out (LIFO)?

In FIFO, the oldest produced goods are sold first. And in the case of LIFO, the most recently produced goods are sold first. Both of these methods are fundamentally different and because of this variables like cost, price and tax are highly affected. LIFO and FIFO methods take into account different assumptions for managing inventory.

Following are the observations after following the FIFO and LIFO principles of inventory management (All these observations are made for an inflationary market):

FIFO:

  • (COGS) Cost Of Goods Sold: The cost of goods sold is less as the earlier produced goods were cheaper, compared to the recent goods.
  • Ending inventory: As the recently produced goods are more expensive. Hence the ending inventory is of higher valuation.
  • Profit: The COGS for FIFO is low, because of this the profit generated by the company is high.

LIFO:

  • (COGS) Cost Of Goods Sold: The COGS is more as the recently produced goods are expensive, compared to the older goods.
  • Ending inventory: In the case of LIFO, the ending inventory consists of older goods. Because of this, the value of ending inventory is low.
  • Profit: The COGS for LIFO is high, because of this the profit generated by the company is less.

What is the difference between First In, First Out (FIFO) and Weighted Average Cost (WAC)?

First In, First Out (FIFO) and Weight Average Cost (WAC) are both asset and inventory valuation methods. First in, First out method is used when the cost of the product is not assigned to a particular product. This means that a product can have different costs during a period of time and when a product is sold, the oldest cost that product had is assigned to it.

The Weighted Average Cost on the other hand is used when the products are so similar and the costs are similar as well. The average cost is taken in this case.  

Another difference between FIFO and WAC is that the FIFO method is globally accepted and widely used. WAC, on the other hand, is rarely used by companies worldwide. In FIFO the oldest available inventory is issued first. In WAC the inventory is issued by averaging the price.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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