What is the FIFO Method?

FIFO, or the First In First Out method, is a form of inventory costing that enables a company to determine the valuation of the amount of inventory that is left at the end of a financial year.

For companies and organizations that produce goods, inventory management is an important part of the end of the year documents that they release, and thus, this method plays a major role in the Balance Sheet released by the company.

Investors who are looking to acquire the company or are interested in buying their stocks and shares also take a keen interest in the inventory management and costing of the organization.

Inventory is simply the number of goods that a company has in reserve, or the number of goods that are in the process of being produced.

Understanding the methods of inventory valuation of a company helps many parties make important financial decisions regarding the business of that company.

Any asset that is intended for sale is a part of the inventory, so companies usually have large stockpiles of inventory that are stored for the purpose of selling at any given point.

The goods that are entered as inventory first are the ones that are sold or disposed first. This means that, as newer goods start entering the inventory list, they are put at the end of the line.

The items that have been there longest will be the ones that are sold immediately. This inadvertently means that, at the end of the financial year, the items that will be left on the inventory list are those that have been introduced into the list most recently.

There is a formula that all companies make use of to calculate their inventory cost, and this formula is used for accounting purposes all over the world.

(Inventory at the start of the year) + (Net purchases) - (Cost of goods sold) = (Inventory at the end of the year)

In simple words, what this means is that, you calculate what the company has at the beginning of the year, add whatever they have purchased during the year, subtract whatever they have sold during the year, and the resultant figure is the inventory left at the end of the year. Its ramifications make for interesting readings in most company's accounts.

The following example will help you understand the method in greater detail. Assume that a product is manufactured in 3 batches (Batch 1, Batch 2, Batch 3) during the year. Let the number of items manufactured per batch be 2,000 pieces, 1,500 pieces, 1,700 pieces respectively and the total cost of production be $8,000, $7,000, $7,700 respectively.

Now, say the company sold 4,000 units during the entire year. Since the total units produced are 5,200, this leaves an inventory of 1,200 items at the end of the year.

Therefore, out of the 4,000 units sold, the first 2,000 units from batch 1 cost $4 per unit. The next 1,500 units from batch 2 cost $4.667 per unit. Out of the 1,700 units left from batch 3, only 500 units were sold, and these cost $4.529 per unit.

The remaining 1,200 units are carried forward to the next financial year at the rate of $4.529 per unit, and this is the figure that will be noted on the Balance Sheet and Profit and Loss Statement of the company.

Inventory valuation is a very important part of a company's accounts, and an investor or an accountant needs to understand the concept completely. FIFO is one of the few universal methods that are used for carrying out effective inventory management.