Inventory valuation methods: FIFO

• As already pointed out in the introduction to inventory valuation methods
• There are several valuation methods that can be used to determine the cost value of inventory
• FIFO- First in First Out is one of these methods
• Assumes that materials/inventories are issued out of inventory in the order in which they were delivered into inventory
• The assumption is that the first items to be bought are the first items to be used
• This is generally a very sound assumption
• For example a fruit seller who buys and sells fruits obviously sell the old fruits first otherwise they would go bad
• Similarly a business that turns meat into sausages would use the meat in order in which it was bought
• This method is appropriate for most types of businesses as a result of this reasonableness

• Above is a summary of the assumptions behind FIFO
• With this method of inventory valuation it is assumed that the oldest items of inventory are sold/used up in productioin first,
• This leaves the business with the most recently purchased items
• This provides an up-to-date valuation method for remaining items of inventory as it uses a recent purchase price to value the majority of goods
• This is especially useful during inflationary periods as FIFO will see inventory being valued at current prices

Example

Itai has closing inventory of 5 units at a cost of $3.50 per unit at 31 December 20X7. During the first week of January 20X8, Itai entered into the following transactions:

• 2nd January – Bought 5 units at $4.00 per unit
• 4th January – Bought 5 units at $5.00 per unit
• 5th January – Sold 7 units at $10 per unit
• 6th January – Bought 5 units at $5.50 per unit

Required:

1. Calculate the value of the closing inventory at the end of the first week using FIFO

Solution to Example

• We assume Itai sold the oldest inventory items first:
• The first 5 items were taken from items from the Opening inventory leaving a deficit of 2 items which were fulfilled by taking from the items bought on 2 January
• This leaves us with the following inventory:
  1. 0 items from Opening Inventory (5-5)
  2. 3 items bought on 2 January (5-2)
  3. 5 items bought on 4 January ( 5-0)
  4. 5 items bought on 6 January (5-0)
• Thus the value of the closing inventory for the week is:

• As shown the items purchased first are considered sold/used first
• The above is a very simple example please click the links below to go to either the ZIMSEC Accounts Level page or the Cambridge AS/A Level page pages and select more examples on the topic

Advantages of FIFO

• It is logical and represents the most logical flow of inventory
• Easily understoond
• Inventory values are up to date i.e. inventory is valued at the most recent prices we paid for it
• Acceptable under the jurisdiction of almost all countries and under IAS 2
• The cost per unit reflects the price actual paid for inventory items

Disadvantages of FIFO

• Issue/Cost of Sales prices might be out of date especially in an inflationary environment for example if we bought inventory for $1 at the beginning of the year and the cost is now $1 000 per year due to inflation this will lead to distorted profit and inventory values
• Profit is inflated during periods of rising prices
• Makes costing comparisons between different jobs different for example the same job might have different material costs

To access more topics go the ZIMSEC Advanced Level Accounting page

To access more topics go to the Cambridge AS/A level page