Understanding FIFO Inventory Valuation: Definition and Example

FIFO method

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FIFO (first-in, first-out) is a method of inventory valuation where the first items purchased or produced are assumed to be the first item sold or used, and the most recent purchases or production costs are retained in inventory. This means that the cost of the oldest inventory is matched against revenue first, leaving the newest inventory costs at the end.

To illustrate how FIFO works, let’s consider an example. A company purchased 100 units of product X on January 1st for $10 per unit, and then purchased 200 units of product X for $12 per unit on February 1st. If the company sold 150 units of product X later that month, the cost of the goods sold under FIFO would be:

– Cost of first 100 units: $10 per unit (the cost of the oldest inventory)
– Cost of next 50 units: $12 per unit (the cost of the newer inventory)

The cost of goods sold would be calculated as follows:

100 units x $10 + 50 units x $12 = $1,700

The remaining 150 units would have a value of:

50 units x $12 = $600

Thus, the value of the ending inventory would be $600 using the FIFO method.

FIFO is considered a common method of inventory valuation because it generally reflects the physical flow of goods in a business. However, it can also result in higher net income and lower cost of goods sold during times of rising prices or inflation, as the oldest and lowest-cost inventory items are matched with current higher revenue amounts.

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