The first-in, first-out (FIFO) method is a widely used inventory valuation method that assumes that the goods are sold (by merchandising companies) or materials are issued to production department (by manufacturing companies) in the order in which they are purchased. In other words, the costs to acquire merchandise or materials are charged against revenues in the order in which they are incurred.

Under first-in, first-out method, the ending balance of inventory represents the most recent costs incurred to purchase merchandise or materials.

The use of FIFO method is very common to compute cost of goods sold and the ending balance of inventory under both perpetual and periodic inventory systems. The example given below explains the use of FIFO method in a perpetual inventory system. If you want to understand its use in a periodic inventory system, read “first-in, first-out (FIFO) method in periodic inventory system” article.

Example:

The Fine Electronics company uses perpetual inventory system to account for acquisition and sale of inventory and first-in, first-out (FIFO) method to compute cost of goods sold and for the valuation of ending inventory. The company has made the following purchases and sales during the month of January 2012.

Jan. 1 Inventory at the beginning of the month: 24 units @ $1,000 per unit.
Jan. 4 Sales: 16 units.
Jan. 7 Purchases: 12 units @ $1,020 per unit.
Jan. 10 Purchases: 10 units @ $1,050 per unit.
Jan. 14 Sales: 16 units.
Jan. 23 Sales: 12 units.
Jan. 24 Purchases: 12 units @ $1,060 per unit.
Jan. 27 Purchases: 4 units @ $1,080 per unit.
Jan. 29 Sales: 6 units.

All sales have been made @ $1600 per unit.

Required:

  1. Prepare journal entries to record the above transactions under perpetual inventory system.
  2. Prepare a FIFO perpetual inventory card.
  3. Compute the cost of goods sold and the cost of inventory in hand at the end of the month of January 2012.

Solution:

(1). Journal entries:

January 4:
The Fine electronics company has sold 16 units for $25,600 (16 units × $1,600) on 4 January. On this date, 24 units in the beginning inventory are the only units available for sale. The cost of goods sold is, therefore, $16,000 (16 × $1,000). In a perpetual inventory system, two journal entries are made for the sale of inventory – one to update inventory account and one to record sale. These are given below:

Date Description Debit Credit
Jan. 04 Accounts receivable 25,600  
       Sales   25,600
  (16 units sold @ $1,600 each)    
  ————————————————-    
  Cost of goods sold 16,000  
        Inventory   16,000
  (Cost of 16 units sold)    

January 7:
The following entry would be made to record the purchase of 12 units @ $1,020 per unit on 7 January:

Date Description Debit Credit
Jan. 07 Inventory 12,240  
       Accounts payable   12,240
  (12 units purchased @ $1,020 each)    

January 10:
The following entry would be made to record the purchase of 10 units @ $1,060 per unit on 10 January:

Date Description Debit Credit
Jan. 10 Inventory 10,600  
       Accounts payable   10,600
  (10 units purchased @ $1,030 each)    

January 14:
According to FIFO assumption, first costs incurred are first costs expensed, the cost of 16 units sold on 14 January would, therefore, be computed as follows:

Cost of 8 units: 8 units × $1,000 = $8,000 (From beginning inventory)
Cost of 8 units: 8 units × $1,020 = $8,160 (From units purchased on 7 January)
      ———–  
Total cost of 16 units sold on 14 January = $16160  
      ———–  

The journal entries for the above sales would be made as follows:

Date Description Debit Credit
Jan. 14 Accounts receivable 25,600  
       Sales   25,600
  (16 units sold @ $1,600 each)    
  ————————————————-    
  Cost of goods sold 16,160  
        Inventory   16,160
  (Cost of 16 units sold)    

January 23:
According to first-in, first-out (FIFO) method, the cost of 12 units sold on 23 January is computed below:

Cost of 8 units: 4 units × $1,020 = $4,080 (From units purchased on 7 January)
Cost of 8 units: 8 units × $1,050 = $8,400 (From units purchased on 10 January)
      ———–  
Total cost of 12 units sold on 23 January = $12,480  
      ———–  

The journal entries for the above sales would be made as follows:

Date Description Debit Credit
Jan. 23 Accounts receivable 19,200  
       Sales   19,200
  (12 units sold @ $1,600 each)    
  ————————————————-    
  Cost of goods sold 12,480  
        Inventory   12,480
  (Cost of 12 units sold)    

January 24:
On January 24, the following entry would be made to record the purchase of 12 units @ $1,060 per unit.

Date Description Debit Credit
Jan. 10 Inventory 12,720  
       Accounts payable   12,720
  (12 units purchased @ $1,060 each)    

January 27:
On January 27, the following entry would be made to record the purchase of 4 units @ $1,080 per unit.

Date Description Debit Credit
Jan. 27 Inventory 4,320  
       Accounts payable   4,320
  (4 units purchased @ $1,080 each)    

January 29:
According to first-in, first-out (FIFO) method, the cost of 6 units sold on 29 January is computed below:

Cost of 2 units: 2 units × $1,050 = $2,100 (From units purchased on 10 January)
Cost of 4 units: 4 units × $1,060 = $4,240 (From units purchased on 29 January)
      ———–  
Total cost of 6 units sold on 29 January = $6,380  
      ———–  

The journal entries for the above sales would be made as follows:

Date Description Debit Credit
Jan. 29 Accounts receivable 9,600  
       Sales   9,600
  (12 units sold @ $1,600 each)    
  ————————————————-    
  Cost of goods sold 6,380  
        Inventory   6,380
  (Cost of 12 units sold)    

(2). FIFO perpetual inventory card:

Companies using perpetual inventory system prepare an inventory card to continuously track the quantity and dollar amount of inventory purchased, sold and in hand. This card is known as perpetual inventory card. A separate perpetual inventory card is prepared for each inventory item. This card has separate columns to record purchases, sales and balance of inventory in both units and dollars. The quantity and dollar information in these columns are updated in real time i.e., after each purchase and each sale. At any point in time, the perpetual inventory card can, therefore, provide information about purchases, cost of sales and the balance in inventory to date.

The perpetual inventory card of Fine Electronics company is prepared below using FIFO method:

Date Purchases Sales Balance
1st Jan. Beginning balance   24 units × $1,000 = $24,000
04 Jan.   16 units × $1,000 = $16000
8 units × $1,000 = $8,000
07 Jan. 12 units × $1,020 = $12,240
  8 units × $1,000 = $8,000
12 units × $1,020 = $12,240
10 Jan.  10 units × $1,050 = $10,500
   8 units × $1,000 = $8,000
12 units × $1,020 = $12,240
10 units × $1,050 = $10,500
14 Jan.   8 units × $1,000 = $8,000
8 units × $1,020 = $8,160
$16,160
4 units × $1,020 = $4,080
10 units × $1,050 = $10,500
23 Jan.
  4 units × $1,020 = $4,080
8 units × $1,050 = $8,400
$12,480
2 units × $1,050 = $2,100
24 Jan.  12 units × $1,060 = $12,720
  2 units × $1,050 = $2,100
12 units × $1,060 = $12,720
27 Jan. 4 units × $1,080 = $4,320
  2 units × $1,050 = $2,100
12 units × $1,060 = $12,720
4 units × $1,080 = $4,320
29 Jan.   2 units × $1,050 = $2,100
4 units × $1,060 = $4,240
$6,340
8 units × $1,060 = $8,480
4 units × $1,080 = $4,320
Total   $39,780  $50,980  $12,800

(3). Cost of goods sold (COGS) and ending inventory:

With the help of the above inventory card, we can easily compute the cost of goods sold and ending inventory.

a. Cost of goods sold (COGS) = [$16,000 + $16,160 + $12,480 + $6,340]*
    = $50,980
b. Ending inventory = [$8,480 + $4,320]**
    = $12,800

* The total of sales column of perpetual inventory card.
** The balance at 29 January – at the end of balance column.