Advantages and disadvantages of first-in, first-out (FIFO) method
Posted in: Inventory costing methods (explanations)
Advantages of FIFO method
The first in first out (FIFO) method of inventory valuation has the following advantages for business organization:
- FIFO method saves money and time in calculating the exact cost of the inventory being sold because the cost will depend upon the most former cash flows of purchases to be used first.
- It is a simple concept which is easy to understand. Even a layman can grab the idea with little explanation. The managers with little to no accounting information would be able to understand it easily.
- It is a fairly practical approach to use, as sometimes it becomes difficult to identify the costs of the products sold at the point of sale and FIFO rectifies the matter.
- It is a widely used and accepted approach of valuation which increases its comparability and consistency.
- It makes manipulation of the income reported in financial statements difficult, as under FIFO policy there remains no vagueness about the values to be used in cost of sales figure of profit/loss statement.
- FIFO will show increased gross and net profits in times of increasing prices of goods.
Cost of sales = opening stock + Purchases – closing stock
This is because the “cost of sales” consists of figure of inventory and as first inventories will have less cost than recent inventories during inflation, the profits reported would be higher.
Disadvantages of FIFO method:
The major disadvantages of using a FIFO inventory valuation method are given below:
- One of the biggest disadvantage of FIFO approach of valuation for inventory/stock is that in the times of inflation it results in higher profits, due to which higher “Tax Liabilities” incur. It can result in increased cash out flows in relation to tax charges.
- FIFO may not be a suitable measure in times of “hyper inflation”. In such times there exist no reasonable pattern of inflation and prices of goods could inflate drastically. And in such cases the matching of most prior purchases with most recent sales would not be appropriate and may pump up profits to present a distorted picture.
- FIFO will not be an appropriate measure if the materials/goods purchased have fluctuating price patterns, because this can result in misstated profits for the same period as different costs of same goods during that same period are recorded.
- FIFO pricing valuation method although easy to understand may get clumsy and cumbersome to operate and extract the costs of goods, as substantial amount of data is required thus resulting in clerical errors.
- Just like any other pricing technique, FIFO is based upon the rates of inflation. This oversimplifies the calculation of the figure of costs because the costs may also absorb the effects of many other different variables like supply and demand, transfer pricing, foreign exchange movements (in case of overseas purchases) etc. and so inventory valuation must be dependent upon all the relevant factors involved.
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