First In First Out (FIFO) | Inventory Cost Flows

Summary

In this video, James from Accounting Stuff explains the FIFO (First In, First Out) inventory cost flow assumption method. He walks through a practical example of how to calculate cost of goods sold and closing inventory using FIFO, which assumes that the oldest inventory is sold first. The video covers four essential steps: drawing a cost flow table, filling it out with known information, calculating total costs, and determining the final cost of goods sold and closing inventory. James highlights the impact of FIFO in an inflationary economy and its effect on profits and taxes.

Takeaways

• 😀 FIFO stands for First In, First Out, which is one of the inventory cost flow assumptions used in accounting.
• 😀 Inventory cost flow assumptions help determine the cost of goods sold (COGS) and closing inventory when inventory prices fluctuate.
• 😀 The FIFO method assumes that the oldest inventory items are sold first, making it easier to account for cost flows in periods of rising prices.
• 😀 To calculate COGS and closing inventory using FIFO, a 4-step process is followed: creating an inventory cost flow table, filling in known information, calculating the total cost of goods sold, and determining closing inventory.
• 😀 An inventory cost flow table consists of five columns: date, description, quantity, cost per unit, and total cost.
• 😀 Under FIFO, when you sell inventory, the cost of goods sold is calculated by taking the cost of the oldest items in stock.
• 😀 For example, if 500 units are sold, the cost of goods sold is the sum of the oldest units, calculated as 220 units from opening inventory and 280 units from additions.
• 😀 The FIFO method results in a higher gross profit in an inflationary environment, as older, cheaper inventory is matched against current revenues.
• 😀 Although FIFO increases gross profit, it can also lead to higher taxes due to the higher reported profits, which could negatively impact cash flow.
• 😀 The video introduces FIFO but also mentions that LIFO (Last In, First Out) and AVCO (Average Cost) will be covered in future videos, allowing viewers to explore other methods.
• 😀 The FIFO method is easy to use and is one of the most commonly applied cost flow assumptions in practice, particularly in industries where prices are rising.

Q & A

What is FIFO in inventory accounting?

FIFO stands for First In, First Out. It is an inventory cost flow assumption where the oldest inventory items are sold first. This method assumes that the first units purchased are the first ones to be sold.

Why do we need Inventory Cost Flow Assumptions?

Inventory Cost Flow Assumptions help businesses allocate costs when inventory is purchased at different prices over time. They determine how costs flow out of inventory into the cost of goods sold and how much remains in the closing inventory.

What are the other types of inventory cost flow assumptions besides FIFO?

The other main types of inventory cost flow assumptions are LIFO (Last In, First Out) and AVCO (Average Cost).

How does FIFO affect gross profit in an inflationary economy?

In an inflationary economy, FIFO can increase gross profit because it sells the older, cheaper inventory first, leaving the more expensive inventory in stock. This can make the business appear more profitable, but may also lead to higher taxes.

What is the first step in using the FIFO method to calculate inventory costs?

The first step is to draw an inventory cost flow table, which consists of five columns: date, description, quantity, cost per unit, and total cost.

What should you enter in the inventory cost flow table during Step 2?

In Step 2, you enter all the known information, such as the opening inventory, the purchases made, and the quantities and costs of the items involved. This helps fill out the table for further calculations.

How do you calculate the total cost of goods sold under FIFO?

Under FIFO, you start by selling the oldest inventory first. For example, if you have 220 units at $2 and 280 units at $3, you multiply the quantities by their respective costs and add the totals to get the total cost of goods sold.

How do you determine the closing inventory using FIFO?

The closing inventory is determined by subtracting the total number of units sold from the total available units. The remaining inventory is valued at the most recent purchase prices.

What happens to your inventory cost flow table after each transaction?

After each transaction (purchase or sale), you leave an empty row in the table for subtotals. This allows you to update the remaining inventory and calculate the total cost of goods sold or closing inventory.

Why is it important to understand FIFO when managing inventory?

Understanding FIFO is important because it affects the valuation of your inventory, the calculation of cost of goods sold, and ultimately, your business's profitability and taxes. It is especially useful in times of rising prices, as it helps businesses better reflect the value of their older, lower-cost inventory.