Why fifo method

Another way to express the FIFO concept is that it expects the first items put into inventory will be the first ones to go out. The definition of inventory includes goods on hand that you plan to sell, whether your company produced them, or purchased them for resale.

For example, if your business builds engines for passenger cars and uses the FIFO method, then your accounting system assumes that the motors you made last month will ship to buyers before the ones made more recently. At the end of the year, when it's time for the inventory count, FIFO assumes that what is on hand consists of the goods placed into inventory most recently. One important thing to remember is that the FIFO system is a set of assumptions about the way your business operates.

It does not extend to the handling of physical products. In practice, the company could be moving assets in a different order. This method assumes that the last products to enter the inventory will move out first.

If we continue with the previous example, the value of your inventory would be based on the cost to produce the engines you made yesterday as opposed to the cost to build the ones you made last month.

This method calculates the average cost by dividing the cost to produce all the goods in the current inventory by the number of those items available for sale. This cost then applies to all items. Specific inventory tracing is yet another method of inventory valuation. For a company to use this method, it must know the cost of all the components that go into a finished product.

That information allows the company to keep track of the precise cost to produce a specific item, which is a more complicated process. The inventory valuation method you choose gives you an operational definition for several factors related to your business.

The data derived from the valuation gives you the ability to apply critical thinking skills to critical strategic decisions. How a company assesses the value of the inventory on hand affects the calculations that determine profit, which in turn affects how much the business pays in income taxes. A lower profit equals a lower tax bill.

The assignment of costs happens at the time of a sale. The assignment happens in the order in which the goods are purchased or in the order in which the goods are manufactured. The FIFO method requires that what comes in first goes out first.

For example, if a batch of 1, items gets manufactured in the first week of a month, and another batch of 1, in the second week, then the batch produced first gets sold first. The logic behind the FIFO method is to avoid obsolescence of inventory. Hence, a company sells or assigns the cost of the first batch of production to the first sale.

Accordingly, the oldest goods get disposed of first while the new ones remain in stock. An entity must choose a method carefully and should follow it consistently. A company can choose any method of valuation. Also, the method of stock valuation affects the income of the company. Products IT. This information helps a company plan for its future. A company also needs to be careful with the FIFO method in that it is not overstating profit.

This can happen when product costs rise and those later numbers are used in the cost of goods calculation, instead of the actual costs. Sal opened the store in September of last year. Right now, it is just the one location but he may expand in the next couple of years depending on whether he can make good money or not.

January has come along and Sal needs to calculate his cost of goods sold for the previous year, which he will do using the FIFO method. Month Amount Price Paid. Both are legal although the LIFO method is often frowned upon because bookkeeping is far more complex and the method is easy to manipulate. Typically these costs have risen over time. Reduced profit may means tax breaks, however, it may also make a company less attractive to investors. The value of remaining inventory, assuming it is not-perishable, is also understated with the LIFO method because the business is going by the older costs to acquire or manufacture that product.

That older inventory may, in fact, stay on the books forever. Investors and banking institutions value FIFO because it is a transparent method of calculating cost of goods sold. It is also easier for management when it comes to bookkeeping, because of its simplicity.