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Understanding FIFO Cost Flow Assumptions

(Last Updated On: October 26, 2018)

In order to properly report their cost of goods sold, companies must resort to one of the three inventory valuation methods. These include the so-called FIFO, LIFO, and the weighted average cost flow assumptions. The FIFO method, which stands for the First-In First-Out, will remove the oldest items from the inventory first. Contradictory, Last-In First-Out (LIFO) will first get rid of the items that were produced recently. Lastly, the weighted average method simply takes the average of all units and expenses them at the same cost.

Why the different methods?

Although there are many reasons why companies resort to using one of the aforementioned inventory costing methods, the SEC originally intended to provide businesses with alternatives depending on their inventory’s spoilage and customization. For instance, companies that produce liquid products like chemicals or fuel may be unable to distinguish between the first and the last gallon. Thus, they get to use the weighted average.

LIFO and FIFO, on the other hand, are more closely related to income statement manipulations that will result in less taxable income. For instance, if one is experiencing a period of rising costs, they will seldom use the FIFO inventory method. Instead, they will charge the latest costs of production to their revenues in order to reduce the taxable income. Thus, the LIFO method will be more likely to come into play when inflation is taking place or the raw material costs are going up.

FIFO, on the other hand, will give one a more accurate depiction of their ending inventory. Consider, for example, a tech-based company that sells laptops. If they have 200 laptops from 2016 that are worth $200 each and another 200 from 2018 that are worth $300 each, they will first write off the costs of the older ones. So, the amount left in their ending (read unsold) inventory will be based on the cost of those laptops from 2018. Hence how it is a more recent depiction of their inventory valuation on the balance sheet.

Disadvantages

As with nearly everything in accounting, both LIFO and FIFO come with a few disadvantages. LIFO’s main disadvantage will be the fact that it can result in lower operating profits. Although this is beneficial for tax purposes, it is not great for a company to report fewer earnings. In fact, doing so can be very repulsive to potential investors.

FIFO, on the other hand, has an issue when it comes to consistency. If one is constantly charging their oldest costs against their recent revenues, they will frequently see discrepancies in the profits. For instance, if those computers from 2016 are sold for $500, the company has a $300 profit. If the ones from 2018 go for the same price, however, the profit is now only $200. So, having to constantly change one’s asking prices to account for the rising costs under FIFO may be an issue for someone’s customers.

Using FIFO and Changing Methods

One of the most popular examples for companies that use FIFO are businesses with perishable goods. Think about a company that sells milk. In order to avoid spoilage, they must get rid of the oldest batches first. Thus, the FIFO inventory method makes much more sense in their case.

If a business decides to change their cost flow assumption, the SEC will generally permit this if certain rules are followed. First, the change will have to be retrospective. Meaning, it will result in a restatement of some of the annual reports and balance sheet for the previous few years. Additionally, the IRS must be properly notified and certain forms must be completed. Nevertheless, most companies avoid going through this procedure as the benefits are heavily outweighed by the costs.

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