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Consumers may be aware of the phrase ‘first come, first serve’; similarly, in business prospects, there is a popular methodology commonly known as First In, First Out, or FIFO. This method speaks about products that are manufactured and produced first and sold first. In this method, the items made first get sold first, rather than other products sending off a different item.
In terms of FIFO, the oldest asset on the stock is included in the cost of goods sold at the time of integrating the income statement. Apart from the cost of goods sold, the remaining items in the inventory get sorted under the most recent purchases. This methodology is required in assuming the cash flow of the business.
FIFO recognizes the first manufactured item and then goes on to the next and so on. There is a basic chronology used in this metric. The process naturally helps reduce the inventory's financial value by removing it from the company’s ownership. In other words, FIFO is one of the common ways of calculating the cost of inventory assets.
The financial market is in a constant state of inflation and price hikes. This becomes the perfect condition for introducing FIFO to the business. FIFO’s basic metric of choosing the oldest goods, the manufacturing cost of these products remains somewhat low compared to new goods on the list. The newer inventory products naturally have a high manufacturing cost. Eventually, this pays off in a better net income number.
Other Valuation Methods Like FIFO
As we have established how the FIFO method works, it is important to know that this is not the only method available out there. We will be discussing a few methods that have been commonly in use for calculating inventory costs and experiencing business growth through increased profit.
Average Cost Inventory
As the name suggests, this method takes up an average cost for manufactured products and puts it into every product. In this case, the whole inventory cost is added and divided by the total number of finished items on sale. This is a simple way of earning net profit. The average cost inventory method allows the inventory balances to stay between FIFO and LIFO.
LIFO
We have been talking about FIFO all this time, and LIFO represents its direct opposite. In that sense, LIFO considers the newest manufactured item first. This is not a good method to consider for an inflated market. In a market consumed with inflation, using LIFO is likely to give you a deflated net income and a low ending balance, whereas FIFO does the opposite.
Specific Inventory Tracing
A specific inventory tracing method requires a few things first to get started. And the most crucial thing is the price of each finished good. If only the company had a fair idea about all the components used in producing the finished product. Without this rare insight, the business cannot simply use the specific inventory tracing method. If you are unsure about certain aspects of product manufacturing, it is wise to go with LIFO or the average cost inventory method.
How Can FIFO Inventory Be Impactful In Evaluating The Financial Statement?
Now that you know the different inventory evaluation techniques used in building the financial statement. Each method has a different approach towards and considers different aspects of the business condition in evaluating the financial statement. So, the question remains, how the FIFO method impacts the Financial Statement?
As we have mentioned earlier, the FIFO method is known for producing an approximation of the market value of the items stored in the inventory. This method takes note of the latest costs associated with manufacturing products that are available under the inventory. This way, the current market value of the inventory gets reflected on the balance sheet.
FIFO naturally contributes to better inventory information and brings it out on the balance sheet. Though FIFO is great in some aspects, in terms of considering the expenses of the oldest item getting recognized the first, the income statement gets poorly matched. There is a clash when it comes to matching revenue and expenses as the sale of inventory is matched to an outdated costing.
Conclusion
Nevertheless, FIFO is a well-accepted method in the evaluation of the financial statement of a company. It is quite useful in matching the expected cash flow with the actual goods flow, revealing a better view of the inventory cost.
