Inventory management is one of the biggest roles of a business. It is very important for businesses to understand the nature of their business and their stocks of goods and accounting. Once a business has understood the nature of their goods and how fast the stocks are rolled in and rolled out they need to decide the accounting system that is followed in the business. There are majorly 3 types of inventory accounting that goes on which are known as LIFO, FIFO and Weighted Average System. In this article, we’re going to discuss FIFO at length. The full form of FIFO, the method of FIFO and when it is used, and examples to understand FIFO better.
The FIFO full form is – First In First Out. FIFO is a very simple and easy to understand inventory accounting system but cannot be used in all nature of businesses and can be used only in specific businesses that are perishable products or fresh produce and so on. At the end of the day, it is upon the business and the owner that needs to decide what method is best for the business, for accounting purposes and for tax purposes.
What is FIFO and how is the method calculated?
First In First Out – FIFO is an inventory management system that is used in businesses to keep a track of the inventory and for accounting. First in first one is when the goods that come in first in the inventory stock are then sold off first and are accounted for accordingly in the books of account for the business. Under the First In First Out, FIFO inventory accounting management system, the oldest products that are in the inventory need to be sold off first and the same rules apply when they are being accounted for in the balance sheet and profit and loss statement.
Because First In First Out, FIFO uses a method wherein the oldest products are sold off first, the prices that are reflected in the books of account and balance sheet are not the latest in value since they account for the earlier prices of goods and supplies. This can be beneficial to a company when the prices of goods are falling down and it can be a disadvantage when the prices of goods are increasing. We will address this in the latter part of the article. Based on the nature of your business, the credit period of goods, whether your goods and business is a cyclical or non-cyclical business you need to decide whether First In First Out, FIFO is the right inventory accounting management system for your business or no.
What are the advantages of FIFO – First In First Out?
First In First Out, FIFO is an easy-to-understand accounting system, which has quite a few benefits amongst the businesses and owners. While Last In First Out is also easy to understand, in India, most businesses either use the Weighted Average method or the First In First Out, FIFO method because of its ease and adaptability. Some of the benefits of First In First Out, FIFO method are:
- This method is very easy to understand and can be adapted by any business easily, irrespective of the nature of their business.
- The accounting system for First In First Out is very easy since it takes into accounts the prices of goods as and when they come and enter those in the balance sheet according to those prices. Due to this, the documentation and paperwork of this method are also easy to adapt.
- Since older products are sold first, the latest products will always be in the inventory keeping in mind the latest products in the business which makes it trendy and up to date too.
- Accounting is easy. Since the prices reflect their true value the job can be done by anybody and hence it is not necessary for a business to hire an expert or a Chartered Accountant for this job which saves on time and cost.
- Accuracy not only in terms of the accounting and balance sheets but also in terms of keeping track of the stock of inventory that is sold and not sold.
While First In First Out has major advantages attached to it, there are some disadvantages too. While this is not a hindrance, it is just something that should be considered while using the First In First Out inventory accounting system.
- During the FIFO system, sometimes profit can be overstated since the olden prices of goods and services are taken into consideration. Due to this, during a period of falling prices, the older goods will be more costly, increasing the profits on the balance sheet. While this may seem like profits are increasing, it is just during an economic period and one needs to keep in mind that the profits will not sustain for a longer period of time.
First In First Out, FIFO Accounting Inventory Example
While we have covered the theory of First In First Out, FIFO the best way to understand this system is via an example and understanding it with a few numbers.
Sirocco Goods and Stationery Shop is using the First In First Out, FIFO method for their stationery accounting inventory practices. They bought branded pens worth INR 100 per pen for a quantity of 1000 and branded colour paints worth INR 200 for a quantity of 100. This is what the transactions look like
1000 Branded Pen = INR 100 x 1000 = INR 1,00,000
100 Color Paints = INR 200 x 100 = INR 20,000
In the middle of the month, they added 500 branded pens at INR 150 and 50 colour paints at INR 250.
500 Branded Pen = INR 150 x 500 = INR 75,000
50 Color Paints = INR 250 x 50 = INR 12,500
By the end of the month, they sold 1200 branded pens and 120 colour paints. But since they follow the First In First Out, FIFO method for inventory management, the 1000 branded pens will be at INR 100 and the remaining 200 will be at the later cost of goods at INR 150.
The same goes with the colour paints. The initial 100 will be at the first price of INR 200 and the remaining 20 will be at the later price of INR 250. This is what the accounting and calculations of this transaction will look like:
1000 Branded Pen = INR 100 x 1000 = INR 1,00,000 [Old Stock]
200 Branded Pen = INR 150 x 200 = INR 30,000 [New Stock]
100 Colour Paints = INR 200 x 100 = INR 20,000 [Old Stock]
20 Color Paints = INR 250 x 20 = INR 5000 [New Stock]
Even though one could take and fill up the quantity with the newest product, since they are following the First In First Out system, the earlier inventory needs to be completely over for them to then switch onto the newer inventory. While the inventory may be the same, this has to be reflected in the prices and on the balance sheet or profit and loss statement.
This is everything one needs to know about the First In First Out, FIFO method.
FAQs about FIFO
- What is the full form of FIFO
FIFO stands for – First In First Out accounting inventory management system.
- What does the FIFO method mean?
The FIFO method means that the goods that have come into the inventory stockpile first are the ones that are sold first and the same price reflects on the accounting systems and in the balance sheet and profit and loss statement.
- Are there FIFO inventory management softwares?
Yes! There are multiple online cloud computing inventory softwares that are available for free or premium versions for businesses to adapt. This not only makes the job very easy due to technology, but it is also easy to understand and all the data is always stored because of the cloud computing features.
- Which method is more common in India? FIFO LIFO or Weighted Average?
First In First Out, FIFO and Weighted Average are the two accounting systems that are allowed in India. As per the latest rules, businesses aren’t allowed to adopt the LIFO system in India. This makes FIFO the most common inventory accounting management system in India.
- What is the difference between FIFO and LIFO?
FIFO stands for First In First Out and takes into account the oldest inventory that needs to be sold. LIFO stands for Last In First Out and takes into account the latest inventory that needs to be sold first.