When a business buys identical inventory units for varying costs over a period of time, it needs to have a consistent basis for valuing the ending inventory and the cost of goods sold. You’re free to choose the inventory system that works best for your business, but the GAAP requires you to be consistent. In other words, if you choose FIFO, you have to use it for COGS and inventory valuation. And you also have to use the same method for future accounting periods. Specific inventory tracing, also known as the specific identification method, is the most involved and time-consuming method of all four since it involves using the actual COGS for each product sold. It can only be used when you know the price of all components of a product and can trace their costs.
It’s best to consult a tax professional before determining the best methods for reducing taxable income since there are many components that go into calculating a company’s tax liability. The cost of goods sold, inventory, and gross margin shown in Figure 10.11 were determined from the previously-stated data, particular to AVG costing. The LIFO method for financial accounting may be used over FIFO when the cost of inventory is increasing, perhaps due to inflation. Using FIFO means the cost of a sale will be higher because the more expensive items in inventory are being sold off first.
How the FIFO inventory valuation method works
Ultimately, businesses must evaluate their unique needs and circumstances when determining which inventory management system will work best for them. The gross margin, resulting from the LIFO periodic cost allocations of $9,360, is shown in Figure 10.10. The gross margin, resulting from the FIFO periodic cost allocations of $7,200, is shown in Figure 10.8. Let’s return to the example of The Spy Who Loves You Corporation to demonstrate the four cost allocation methods, assuming inventory is updated at the end of the period using the periodic system.
So the ending inventory would be 70 shirts with a value of $400 ($100 + $300). Investors and banking institutions value FIFO because it is a transparent method of calculating cost of goods sold. It is also easier for management when it comes to bookkeeping, because of its simplicity. It also means the company will be able to declare more profit, making the business attractive to potential investors. One of the biggest advantages of FIFO is that it helps businesses sell their oldest stock first. This means that the products in your inventory are less likely to expire before they can be sold, which helps reduce waste.
How to calculate COGS using FIFO?
While this may be seen as better, it may also result in a higher tax liability. For some companies, FIFO may be better than LIFO as this method may better represent the physical flow of inventory. If the company acquires another 50 units of inventory, one may presume that the company will try to sell the older inventory items first.
As a result, the inventory items that were purchased first are recorded within the cost of goods sold, which is reported as an expense on the company’s income statement. FIFO method calculates the ending inventory value by taking out the very first acquired items. Then, since inflation increases price over time, the ending inventory value will have the bulk of the economic value. As the FIFO https://www.bookstime.com/ method assumes we sell first the items acquired first, the ending inventory value will be higher than in other inventory valuation methods. The only reason for this is that we are keeping the most expensive items in the inventory account, while the cheapest ones are sold first. Then, since deflation decreases price over time, the ending inventory value will have less economic value.
Why is FIFO the best method?
Pick the method that works for you and get to work tracking your profit. By understanding what FIFO is and how to use it, you can ensure that your products are sold or used in the order they were received or produced. This allows you to avoid spoilage or obsolescence of goods while ensuring timely delivery to customers. Furthermore, depending on market conditions such as inflation or deflation, FIFO may not always provide an accurate representation of current values due to the use of older pricing data.
Our new inventory quantity available for sale during the period is 130 gallons (100+10+20), with a cost of $285.00 ($200 +$25+$60). The FIFO method can help lower taxes (compared to LIFO) when prices are falling. However, for the fifo method formula most part, prices tend to rise over the long term, meaning FIFO would produce a higher net income and tax bill over the long term. Here’s what it would look like if Archon Optical used LIFO to report on the past three months.
Later on, she bought 150 more boxes at a cost of $4 each, since the supplier’s price went up. Though it’s the easiest and most common valuation method, the downside of using the FIFO method is it can cause major discrepancies when COGS increases significantly. Due to inflation, the more recent inventory typically costs more than older inventory.