first in first out ( FIFO )

FIFO, which stands for "first-in-first-out," is an inventory costing method which assumes that the first items placed in inventory are the first sold. Thus, the inventory at the end of a year consists of the goods most recently placed in inventory. FIFO is one method used to determine Cost of Goods Sold for a business .
Here is how inventory cost is calculated using the FIFO method:
Assume a product is made in three batches during the year. The costs and quantity of each batch are:

• Batch 1: Quantity 2,000 pieces, Cost to produce $8000
• Batch 2: Quantity 1500 pieces, Cost to produce $7000
• Batch 3: Quantity 1700 pieces, Cost to produce $7700

Let's say you sold 4000 units during the year, out of the 5200 produced.
Then calculate the unit costs for each batch:

• Batch 1: 8000/2000 = 4
• Batch 2: 7000/1500 = 4.667
• Batch 3: 7700/1700 = 4.529

·  So, of the 4000 units sold, using FIFO

• The first 2000 units sold from the first batch cost $4 per unit.
• The next 1500 units sold from the second batch cost $4.667 per unit.
• And the last 500 units sold from the third batch cost $4.529.
• The cost of the remaining 1200 units from the third batch is $4.529. These units will start off the second year.

Objectives and Advantages of FIFO Method:

One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it does not permit manipulation of income because the enterprise is not free to pick a certain cost item to be charged to expense.

Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the fist goods in are the first goods out, the ending inventory amount will be composed of the most recent purchases. This is particularly true where the inventory turnover is rapid. This approach generally provides a reasonable approximation of replacement cost on the balance sheet when price changes have not occurred since the most recent purchases.

Disadvantages of FIFO Method:

The basic disadvantages of first in first out method (FIFO Method) are that costs are not matched against current revenues on the income statement. The oldest costs are charged against the more revenue, which can lead to distortion in gross profit and net income.

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