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 interested in acquiring the company or are interested in buying stocks and shares of the company also take a keen interest in the inventory management and costing of the organization.

What is Inventory?
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 inventory valuation methods of a company helps many parties make important financial decisions regarding the business of the 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.

What is FIFO Method?
According to it, 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 inventory 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. Sounds simple enough, but its ramifications make for interesting readings in most company's accounts.

Example
The following example will help you understand the method in greater detail. Assume that a product is manufactured in 3 batches during the year. The number of items manufactured per batch, the total cost of production and the cost per unit are as follows.

Batch Number	Quantity	Cost of Production	Unit Costs
1	2000 pieces	$8000	$4
2	1500 pieces	$7000	$4.667
3	1700 pieces	$7700	$4.529

Now, say the company sold 4000 units during the entire year. Since the total units produced are 5200, this leaves an inventory of 1200 items at the end of the year. Therefore, out of the 4000 units sold, the first 2000 units from batch 1 cost $4 per unit. The next 1500 units from batch 2 cost $4.667 per unit. Out of the 1700 units left from batch 3 only 500 units were sold, and these cost $4.529 per unit.

The remaining 1200 units carry 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 the 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.