The first in first out method (“FIFO”) simply means that what comes in first will be handled first, what comes in next waits until the first one is finished. In other words, FIFO is a method of inventory valuation based on the assumption that goods are sold or used in the same chronological order in which they are bought. FIFO describes the principle of a queue processing technique or servicing conflicting demands by ordering process by first come, first serve behavior.
FIFO is a method of inventory accounting in which the oldest remaining items are assumed to be the first sold. In a period of rising prices, this method results in a higher ending inventory, a lower cost of goods sold, a higher gross profit, and a higher taxable income.
The FIFO method of costing is used to introduce the subject of materials costing. The FIFO method of costing issued materials follows the principle that materials used must carry the actual experienced cost of the specific units used.
The FIFO method assumes that the materials are issued from the oldest supply in stock and that the cost of those units when placed in stock is the cost of those same units when issued. However, FIFO costing can be used although physical withdrawal is in a different order.
The following are considered to be some of the advantages of FIFO method:
- Materials used are drawn from the cost record in a logical and systematic manner;
- Movement of materials in a continuous, orderly manner that represents a condition that is necessary and consistent with the efficient materials control.
However, there are some disadvantages also for the FIFO method. It is to be noted that if frequent purchases are made at different prices and if units from several purchases are on hand at the same time, it will definitely lead to a loss. For example, take a purchase that is made for $500 first and $2000 subsequent to that. As per the FIFO method, the purchase made for $500 has to be sold first. Therefore, the purchase made for $2000 cannot be sold out until the first one is finished. This can sometimes lead to a loss.
It is to be noted that the FIFO method is usually recommended whenever:
- The size and cost of units are large;
- Materials are categorized under a particular purchased lot;
- Two or three different receipts of the materials are on a materials card at the same time.