First-in, first-out (FIFO) is a common inventory valuation method that provides several advantages to businesses, including higher gross profit amounts, increased inventory value on the balance sheet and fewer opportunities for obsolete inventory write-offs. Inventory valuation is an important accounting concept for businesses. Companies use different valuation methods based on the company’s internal policy and the type of inventory sold to consumers. FIFO requires companies to sell the oldest inventory first from the company’s financial inventory account. Companies often maintain detailed records in their accounting ledger in order to follow this principle.
Companies purchasing inventory at various times throughout the year must keep individual records for each purchase. Items are recorded on the accounting ledger at the date and actual cost paid for each item. When selling inventory up, FIFO accounting procedures will remove the oldest items first, even though the actual physical items may not represent the oldest items in the warehouse. Many companies do not keep track of older and newer inventory unless there is a high risk or obsolescence or spoilage involved with the inventory. This valuation method focuses primarily on the company’s accounting ledger.
In theory, selling older inventories first usually removes the cheapest inventory from the company’s inventory asset account to cost of goods sold. Because gross profit is net sales revenue minus cost of goods sold, FIFO results in higher gross profit amounts. While some critics in the accounting profession do not prefer FIFO inventory valuation for this reason, the method does provide businesses with a significant advantage when reporting financial results to internal and external business stakeholders.
Higher inventory value on a company’s balance sheet generally increases the company’s economic value and improves the financial ratio analysis. Economic value often represents a company’s total assets minus total liabilities. A positive number indicates the company has higher economic value in the business environment. Inventory can represent a large asset on the company’s balance sheet. Business owners and managers commonly conduct a financial ratio analysis to assess their company’s ability to meet short-term financial obligations. Large inventory balances are a current asset that improves the company’s financial ratios relating to meeting short-term financial obligations.
FIFO can help companies have lower balances of obsolete inventories in their accounting ledger. Constantly removing older inventories ensures the products with the highest probability of obsolescence will be removed from the general ledger. A company with copious amounts of obsolete inventory that becomes unsellable must write off this amount against the company’s net income. While this write-off reduces the company’s tax liability, external business stakeholders must see it as a weakness in the company’s inventory management process.