Question

In detail discuss what are the advantages and disadvantages of using FIFO for process costing. In periods when costs are increasing how will FIFO affect reported net income? What about in periods of declining costs? Explain.

Answer 1

FIFO method of inventory valuation assumes that the goos which are brought first are sold first. With this assumption the value of cost of goods sold and ending inventory is evaluated.

advantages of FIFO

(1) closing inventory is recorded at cost and therefore there is no unrealised gain or loss on ending inventory.

(2) inventory cost are charged to products in order in which they are incurred.

(3) as the closing inventory represents the cost of most recently purchased or produced goods the inventory value indicates the current value to a large extent.

(4) FIFO method is easy to follow and is cost effective.

(5) the approach is practical as there are times when cost acertainment is quite difficult.

disadvantages of FIFO

(1) it leads to improper matching of cost with revenue since the oldest cost are matched with current revenue.

(2) becomes difficult to operate when the purchases are frequent.

(3) in case of inflations higher pofits are shown which leads to excess tax liability.

(4) incase of fluctuating price of purchases the profits can be misrepresented as same goods are recorded at different values.

in case of increasing costs meaning when the cost of purchases are increasing the FIFO method shows higher profits or net income because most of this profit results from matching current revenues with earlier purchases which were made at lower prices.

when the period cost is declining FIFO method shows lower profits. This is because most of this profit results from matching current revenue with earlier purchases which were made at higher prices.