Disclaimer: Please note this article is not financial advice. The purpose of our blog is purely educational, so please consult a professional accountant or financial advisor before making any financial decision.
Like the barcode system in grocery stores and retail shops, a specific identification method is a sophisticated approach to tracking purchases. The barcode matches with products in your accounting and inventory system and can determine the exact cost of the products when they were purchased. What if you don't have enough resources to enjoy such technology?
Lucky you because the FIFO method formula exists! FIFO is a widely used inventory valuation method and stands for first in, first out. The idea behind this method is that you sell items that were first put into stock before the newer items. Though there are many benefits to this system, it does require some complicated calculations.
Indulge yourself in this article as it walks you through the ins and outs of the FIFO method.
The Cost Flow Assumptions
Cost flow assumptions are methods companies use to determine which costs go into inventory and which go into expense. The costs that go into inventory include:
- Direct materials. These materials, such as raw materials and some intermediate materials, can be physically and directly traced to a specific product.
- Direct labor. This cost is usually applied when the company uses variable costs, such as wages or salaries for its employees.
- Manufacturing overhead. This consists of overheads such as overheads for utilities (gas, electricity, etc.), repairs and maintenance of equipment, insurance, rent on factory building and floor space, general office expenses, depreciation on factory machinery, and equipment.
The costs that go into expense are:
- Administrative expenses - office salaries and wages, advertising costs, telephone bills
- Selling costs/selling expenses - commissions for salespeople or efforts to secure new customers, promotional materials (an example is leaflets), postage, and shipping charges paid by the company to gain more business
The FIFO inventory method is one of the most utilized cost flow assumptions.
The FIFO Method Accounting Explained
FIFO method accounting is a way of valuing inventory using the assumption that the first items to be put into stock are also the first items to be sold. Under this method, the cost of the oldest items in stock is used to value the inventory. This method is often used in cases where the company expects to sell its products soon.
There are a few steps in FIFO method accounting:
- Calculate the cost of goods sold (COGS).
- Record the sale of an item.
- Record the purchase of an item.
- Calculate the inventory at the beginning of the period.
- Calculate the inventory at the end of the period.
The formula for LIFO is as follows:
Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold/Units Sold * Unit Cost = COGS per unit
The beginning inventory consists of all items already on hand at the start of an accounting period, while purchases are all new goods that come into a company's possession during the said accounting period. This assumes that customers had used up any newly purchased goods before older ones that had been sitting around longer. Many companies prefer this method because it allows them to use lower-costing inventory items when determining their financial statements or tax filings. However, it only works if the company has been able to keep track of its inventory properly.
Advantages of the FIFO Method
There are many advantages to the FIFO method. Some of these benefits include:
- The company can concentrate on generating revenue instead of keeping track of its inventory.
- It's easy to calculate because it relies on the assumption that items purchased first were also the ones sold first.
- The company doesn't have to worry about calculating inventory using an average cost rather than a list price.
- This system is time-efficient because it involves only two steps, purchase and sale.
Some people may think that the FIFO method is unfair to consumers who buy the products purchased at a later date at higher prices than what they would have paid if they had bought them at a younger date.
You can do the FIFO accounting method since it is simple. However, you can always ask for professional assistance. If you want to get the right professional, take time to read What Qualities Should You Look For in a Tax Accountant, written by one of our highly experienced accountants here in Unloop.
An Example to Better Understand FIFO Method
You sell a cap for $85 per piece. Then, assume that you had sold 50 pieces from 100 caps in your inventory. You want to see how much profit you have made so far from the 50 pieces you already sold. However, the 100 caps in your inventory were purchased from the same supplier at different prices. See the table below for more information.
| Date of Purchased | Quantity | Price | Total |
| 1/1/2021 | 25 | $50 | $1,250 |
| 2/2/2021 | 50 | $55 | $2,750 |
| 3/3/2021 | 25 | $60 | $1,500 |
Notice the data in the table: You purchased three sets of caps from January to March. You initially had 25 caps for $50 each, and you ordered a second batch that contained 50 caps with a $5 increase for each one. In March, you ordered 25 caps to be in stock with another $5 increase, making a total of $60 in the base price of each cap.
NOTE: Demand and inflation are the major factors that affect the price increase of goods and services.
Since you have sold identical caps and you don't have a barcode system that tells you which ones are from January, February, or March, the FIFO method is one of the best options you have to determine your profit.
Again, you had sold 50 caps at $85 each. All in all, you have a total sale of $4,250. Going back to the table, we need to mark out the 25 pieces in January and another 25 pieces from February to satisfy the total of 50 caps. In January, the 25 caps were purchased for $1,250. Then, you need to get another 25 caps from February and multiply them to $55, and you get $1,375.
To get your gross profit, you need to follow this formula:
REVENUE - COST OF GOODS SOLD = GROSS PROFIT
$4,250 - ($1,250 + $1,375)
$4,250 - $2,625 = $1,625
Your gross profit is $1,625 for the 50 caps sold using the FIFO method.
REMEMBER The Cost Flow Assumptions, like the FIFO method, influence the tax you need to pay, so you have to be very careful in selecting the right method you'll use for your business.
Final Thoughts
The FIFO method is an inventory management formula that helps companies keep track of their products and calculate the cost of goods sold to file financial statements or tax returns accurately. If you have an online business like a shop on Amazon marketplace, you can use FIFO if you don't have a barcode system to better track your sales and inventory.