Which inventory cost flow assumption would you use to optimize net income?

The First In First Out (FIFO) is a method for asset management that ensures assets we produce or acquire first are the ones we use or sell first.

Under FIFO, we include the oldest assets’ cost in the Cost of Goods Sold (COGS) line item on the Income Statement.

FIFO supports our assumptions for the cost flow within the company. When we use parts and raw materials in the production process and then sell the finished goods, we must recognize the relevant costs. Under the First In, First Out technique, we first recognize the cost of the items we purchased first.

The method follows the logic that a company would sell or use the oldest inventory first, to maintain newer items in our inventory balance and avoid it becoming obsolete.

The cost flow assumptions refer to how we transfer the product cost from inventory to the Cost of Goods Sold. In these terms, inventory is either goods we purchase for resale or goods we produce (including direct material and labor and overhead costs).

FIFO doesn’t track the physical inventory. We may not always sell items from the same product in the same order as we purchase them. However, we assume the oldest items are our first choice for accounting purposes, only tracking inventory totals.

The method’s assumption for inventory flow closely follows the actual flow of goods within most businesses. We consider it theoretically the most accurate inventory valuation method. It’s a logical approach, as it reduces the risk of obsolete inventory.

Under FIFO, we match older historical costs to current revenue through COGS. This way, gross margin does not always allow for the proper matching of revenues and expenses.

If we apply FIFO in a market with rising prices and significant inflation, there are some implications to keep in mind. The method will use the older costs, which are priced lower than the most recent ones. Doing so will result in a higher net income. Also, newer, more expensive items will remain on the Balance Sheet, inflating the inventory’s ending balance.

When we apply the First In, First Out method for inventory costing, it is normal to experience some fluctuations within Cost of Goods Sold (COGS), as the costs in expensed items rely on fluctuating prices.

Apart from FIFO, there are two other popular methods we can employ:

Under this method, we assign the same cost to all items. We divide the total cost of inventory by the available number of items in inventory.

When we apply LIFO, the last items we acquire are the ones we use first. LIFO will produce lower net income and a lower ending balance of inventory in the premise of inflation.

In the United States, companies can apply to use LIFO under some specific circumstances. It is still frowned upon as it makes the accounting process more complicated and easy to manipulate. Under the Last In, First Out method, we use recent, more expensive inventory items first. This reduces profits and corporate tax, which may be appealing to some companies. At the same time, power profits can make the company a less attractive investment opportunity.

The International Financial Reporting Standards (IFRS) do not allow LIFO use and require that businesses employ FIFO instead. As a large part of the world operates under IFRS, many companies in the United States also prefer FIFO.

Another alternative to FIFO is to use specific identification of inventory items. We can apply this approach to unique items with a particular cost. Some examples can be antiquities, jewelry, paintings, and others.

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The First In, First Out method has some benefits. It is easy to understand, well-known, and trusted by professionals. FIFO follows the actual inventory flow, and it provides for easier bookkeeping and is less prone to mistakes.

Under this inventory costing technique, the company experiences less waste, as it manages obsolescence better. FIFO results in an ending balance of inventory closer to market values, as newer, more recently costed items are left.

It helps to achieve a more transparent inventory management process and results in higher profits. FIFO also gives management a clearer view of the company’s financials.

As with all economic concepts, the method also has some drawbacks. In normal circumstances, where the markets experience inflation, FIFO results in a higher gap between selling prices and cost. Due to this, the company experiences higher income tax than other methods. If there’s abnormal inflation or rising prices, the technique can overstate profit and inflate inventory balances.

To better understand how we apply the First In, First Out method, let’s look at a simplified inventory costing example.

Imagine we have a company that purchases and resells one product. We start by purchasing 250 units of it.

Now that we have 250 units available, we can start selling them at a mark-up.

Alongside each sales invoice, we record the decrease in our balance of purchased items.

By our 4th sale (Invoice A004 for 45 units), we face an issue.

We only have 30 units remaining in our inventory balance, and utilizing 45 of these is impossible, as physical inventory cannot be of a negative quantity.

To provide the additional items we require for invoice A004, we will place a second purchase order for 50 additional units. Note that the purchase price has changed from €109.75 to €112.46.

We can service the whole order per invoice A004 from our second purchase. However, as we apply FIFO, we will first deplete the balance units from our first purchase. Only then will we employ units from the second batch we acquired. As these are at a different cost, we will split our A004 invoice into two separate lines.

We will utilize the remaining 30 units from purchase batch P001 first, fully depleting our first purchase order.

Then we will take the remaining 15 units per invoice A004 from our second batch.

As we purchased these additional 15 units at a higher price, the profit margin for sale A004 drops from 32.1% to 31.0% (assuming no change in selling price).

Our next sale will be entirely out of the second batch of units. As it will only use the more expensive items from batch P002, the profit margin will drop even further to 28.9%.

This will leave us with an ending inventory balance of 14 units.

By depleting batch P001 first, we have an ending balance of more recent (and more expensive) units, reflecting a more realistic financial position for the company.

You can download the example model in Excel in the original article.

Investors and financial institutions prefer FIFO as it’s a transparent approach to the Cost of Goods Sold’s calculation. It is easier to manage and allows the company to declare more profit. The First In, First Out method also presents a more accurate ending balance of the remaining inventory.

We commonly use the method to estimate the value of inventory in hand at the end of a reporting period and the Cost of Goods Sold during that same period.

If we use FIFO instead of the Weighted Average Cost or LIFO methods, we show an ending inventory balance consisting of more current costs in the Balance Sheet.

Disclaimer: The information in this article is for educational purposes only and should not be treated as professional advice.

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