How To: Use FIFO Set-off
"First In, First Out", commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first.
Under FIFO, it is assumed that the cost of inventory purchased first will be recognized first. The ₹ value of total inventory decreases in this process because inventory has been removed from the company’s ownership. The costs associated with the inventory may be calculated in several ways—one being the FIFO method.
Example of FIFO
Inventory is assigned costs as items are prepared for sale. This may occur through the purchase of the inventory or production costs, the purchase of materials, and the utilization of labor. These assigned costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first.
Imagine if a company purchased 100 items for ₹10 each, then later purchased 100 more items for ₹15 each. Then, the company sold 60 items. Under the FIFO method, the cost of goods sold for each of the 60 items is ₹10/unit because the first goods purchased are the first goods sold. Of the 140 remaining items in inventory, the value of 40 items is ₹10/unit and the value of 100 items is ₹15/unit. This is because inventory is assigned the most recent cost under the FIFO method.
When Is First In, First Out (FIFO) Used?
The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense. Under FIFO, it is assumed that the cost of inventory purchased first will be recognized first which lowers the dollar value of total inventory.
What Are the Advantages of First In, First Out (FIFO)?
The obvious advantage of FIFO is that it's the most widely used method of valuing inventory globally. It is also the most accurate method of aligning the expected cost flow with the actual flow of goods which offers businesses a truer picture of inventory costs. Furthermore, it reduces the impact of inflation, assuming that the cost of purchasing newer inventory will be higher than the purchasing cost of older inventory. Finally, it reduces the obsolescence of inventory.