First In - First Out (FIFO) - Explained
What is FIFO?
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Table of ContentsWhat is the First In - First Out (FIFO) Accounting Method?How does First In - First Out (FIFO) Work?Illustration of the First In First Out (FIFO) MethodAdvantages of the FIFO MethodDisadvantages of the FIFO MethodAcademic Research on First In, First Out FIFO
What is the First In - First Out (FIFO) Accounting Method?
First In First Out (FIFO), sometimes referred to as Last In Still Here (LISH), is a method of inventory valuation employed in the field of accounting, that is founded on the premise that the sale, usage or disposal of goods follows the same chronological order in which they are bought. In simple terms, the FIFO method mandates that products or assets that have been purchased or manufactured first need to be sold or consumed first. This is often the logical and theoretically correct choice for a business, since disposing of the oldest goods in the inventory on priority greatly mitigates the risks associated with having an obsolete inventory.
How does First In - First Out (FIFO) Work?
A business that follows the First In First Out (FIFO) method updates its balance sheet in such a way that the costs of the inventory assets are matched to the costs of the products most recently manufactured or purchased. It is important to establish here that in a FIFO method, although the oldest assets or products in the inventory are recorded as sold first, it is not always the case that the exact oldest goods present in the inventory are physically disposed at the earliest - it is just that the cost associated with the oldest goods present in the inventory is expended first on the balance sheet.
Back to: ACCOUNTING, TAX, & REPORTING
Illustration of the First In First Out (FIFO) Method
The concept of FIFO can be easily explained with the help of the following example. A luggage retailer, R1 follows the FIFO method. Now, R1 purchased the following consignments of suitcases in a chronological order during the month of April:
|Number of units||Cost per unit|
Now, suppose that during the same month (April), R1 sold a total of 230 suitcases. In this case, applying the FIFO method, R1 would expend its costs on the balance sheet in the following order:
- Expend the cost associated with the first 100 units @ $100, i.e. 100 x $100 = $10,000.
- Expend the cost associated with the next 120 units @ $105, i.e. 120 x $105 = $12,600.
- Expend the cost associated with the remaining 10 units @ $110, i.e. 10 x $110 = $1,100.
Therefore, the total cost of suitcase sales for the month of April would be ($10,000 + $12,600 + $1,100) = $23,700. Now, R1s ending inventory can be calculated as follows: There are 70 units of suitcases remaining at the cost of $110 per unit. Therefore, the total cost of the remaining units will be (70 x $110) = $7,700. As such, R1s balance sheet will display the current value of the inventory as $7,700.
Advantages of the FIFO Method
The FIFO method offers certain advantages to business, such as:
- The process of application of FIFO is relatively uncomplicated.
- FIFO offers a higher quality information about inventory in the balance sheet, with respect to the current market value of assets.
- It is virtually impossible to manipulate income when using FIFO.
- The assumed flow of costs often corresponds to the actual physical flow of goods to a large extent. Thus, understating inventory is improbable.
Disadvantages of the FIFO Method
Despite the several advantages, the FIFO method also has its share of demerits, such as
- During periods of inflation, the FIFO method displays a higher value for the ending inventory, as well as a higher gross profit (especially compared to a Last In First Out or LIFO method). This results in a higher taxable income for the business and thus, a bigger burden of tax.
- The FIFO method typically results in a poorer matching of costs and revenues, compared to a LIFO method. This is because FIFO expenses the oldest costs first, which often results in revenue from the sale of inventory being matched with an outdated cost.
Academic Research on First In, First Out FIFO
- First in, first out: Word learning age and spoken word frequency as predictors of word familiarity and word naming latency, Brown, G. D., & Watson, F. L. (1987). This paper scrutinizes certain claims that advocate the use of subjective measures of word frequency over standard word frequency counts as predictors of the actual frequency of word encounter. The authors conclude that it is not feasible to substitute objective frequency measures with rated familiarity. According to a multiple regression study of word naming latency, rated word learning age is a better predictor of word naming latency than several other variables such as spoken word frequency, written word frequency, and rated familiarity.
- First in, first out? The effects of network externalities on pioneer survival, Srinivasan, R., Lilien, G. L., & Rangaswamy, A. (2004). Journal of Marketing, 68(1), 41-58. This paper highlights the increasingly important role played by network externalities in the economy of a country. These network externalities also have major implications for the marketing strategies of any firm. This paper analyzes the effects of network externalities together with other product and firm attributes on the survival of pioneers.The authors employ an accelerated failure time model to a data sample of 45 office products and consumer durables and conclude that network externalities have a negative main effect on the survival duration of pioneers. On the other hand, network externalities are directly proportional to survival duration in the case of more technologically advanced products.
- GasP: A minimal FIFO control, Sutherland, I., & Fairbanks, S. (2001). In Proceedings Seventh International Symposium on Asynchronous Circuits and Systems. ASYNC 2001 (pp. 46-53). IEEE. The GasP family of asynchronous circuits provides controls for the following: Simple pipelines; Branching and joining pipelines; Round-robin scatter and gather; Data dependent scatter and gather; Join on demand through arbitration. The GasP family design ensures that each stage operates at the speed of a three-inverter ring oscillator. Test chips in 0.35 micron technology demonstrate throughputs that exceed 1.5 giga data items per second (GDI/s). A single wire transmits both request as well as acknowledge messages between GasP pipeline stages. The wire also records the FULL or EMPTY state of each pipeline stage. Transistor widths play a significant role in equalizing the delay in logic gates in GasP control circuits.
- Instability of FIFO queueing networks, Bramson, M. (1994). The Annals of Applied Probability, 4(2), 414-431. This paper analyzes a queueing network where customers arrive according to a rate-1 Poisson process. Each customer uses the exact same predetermined route and waits at various queues until his exit from the system. The author presumes that service times are independent as well as exponentially distributed. Also, a customer may visit an individual queue more than once, with the mean service time being presumed to be dependent on the stage along the route, while the network is assumed to be first-in, first-out (FIFO). An equilibrium distribution can only be achieved in such a network as long as the sum of the mean service times at each queue is less than 1.
- On-the-fly analysis of systems with unbounded, lossy FIFO channels, Abdulla, P. A., Bouajjani, A., & Jonsson, B. (1998, June). In International Conference on Computer Aided Verification (pp. 305-318). Springer, Berlin, Heidelberg. This paper employs representative on-the-fly verification techniques for systems of finite-state machines that communicate through the exchange of messages via unbounded and lossy FIFO queues. The authors use Simple Regular Expressions (SREs) to represent sets of states of protocols with lossy FIFO channels. The paper concludes that the class of languages represented by SREs is the exact class of downward closed languages that make an appearance in the examination of such protocols. The authors provide techniques for evaluating inclusion between SREs, an SRE that depicts the set of states obtainable through the execution of a single transition in a system, and an SRE that depicts the set of states obtainable by an arbitrary number of executions of a control loop of a program.
- Evidence on the choice of inventory accounting methods: LIFO versus FIFO, Dopuch, N., & Pincus, M. (1988). Journal of Accounting Research, 28-59. This paper assesses and highlights the various systematic attributes of annual accounting numbers of both Last In - First Out (LIFO) and First In - First Out (FIFO) firms as well as their counterparts. This data is obtained by estimating probable outcomes that would have been reported by LIFO and FIFO firms if they were to use the FIFO (LIFO) inventory method. The paper aims to offer supplementary evidence on tax as well as non-tax explanations of these firms preference of inventory accounting procedures.
- The LIFO/FIFO Decision, Morse, D., & Richardson, G. (1983). Journal of accounting research, 106-127. This paper utilizes a time-series approach and conducts intra industry comparisons in order to evaluate the inventory costing decisions of certain firms. The authors sample inventory costing decisions over a 41-year period from 1938 until 1978. Such extensive sampling of data enables the authors to gain significant insight and explain the rationale behind accounting decisions.
- The LIFO/FIFO choice: An asymmetric information approach, Hughes, P. J., & Schwartz, E. S. (1988). Journal of Accounting Research, 41-58. This paper describes the development of a model that facilitates certain observations pertaining to a switch from 'first-in, first-out' (FIFO) inventory valuation to 'last-in, first-out' (LIFO) valuation. This particular model has its foundations on the information symmetry between investors, and managers whose LIFO/FIFO choice offers a discreet view of their private information. he results indicate that: securities values will increase if all firms in an industry switch to LIFO; and securities prices can drop if only some firms in an industry switch to LIFO.
- Free cash flow, debt-monitoring and managers' LIFO/FIFO policy choice, Gul, F. A. (2001). Journal of Corporate Finance, 7(4), 475-492. This paper scrutinizes the evaluative capabilities of Jensen's free cash flow hypothesis in managers' choice of last-in, first-out (LIFO) versus first-in, first-out (FIFO). The correlation between free cash flow (FCF) and choice of inventory methods is founded on the premise that there exists a likely conflict of interest between managers and shareholders when LIFO is the method for tax minimization, and that non-value-maximizing managers of firms with the FCF issue are motivated to instead, go for a FIFO setup, which is an income-augmenting method. The primary motive behind choosing a FIFO method is undoubtedly to increase personal compensation.
- The ready-to-go virtual circuit protocol: a loss-free protocol for multigigabit networks using FIFO buffers, Varvarigos, E. A., & Sharma, V. (1997). IEEE/ACM transactions on networking, 5(5), 705-718. The ready-to-go virtual circuit protocol (RGVC) is an immediate transmission protocol that allows the source to transmit data without having to wait for an end-to-end round trip delay for making reservations. The RGVC protocol presents certain advantages over other protocols; for instance, it is compatible with networks where switches use FIFO buffers that are shared by multiple sessions.The RGVC protocol couples link capacity with buffer space. This essentially means that occupying a portion of a buffer at a node results in the freezing of a proportional fraction of the incoming capacity to that buffer. This ensures lossless communication. This paper presents two schemes for the purpose of implementing the requisite bookkeeping function: The measurement-based scheme, where the bookkeeping function is implemented through measurements made in hardware. The estimation-based scheme, where the bookkeeping function is implemented analytically through the exchange of control packets between nodes.