What are the advantages and disadvantages of First In First Out accounting method?

Answer 1

In FIFO inventory valuations the next item you sell is ASSUMED to be the item that has been sitting in inventory for the longest time period. The inventory items I've had in inventory the longest are considered the next ones sold. In essence you're depleting old inventory. In inflationary times the cost of your NEW(or replacement) inventory will be at a higher cost than the inventory you purchased in the past. Thus, if the selling price increases because of inflation you will INCREASE your Net Profit because you are selling the inventory items that cost less. So the advantage is that Net Profit goes up when you use FIFO during inflationary times AND your inventory will be valued at the actual replacement cost. The disadvantages is that if you use FIFO during inflationary times your Net Profit will go up which also means your Tax costs increases. Plus, if the price for the inventory levels off or declines your Net Profit will decline because your Cost of Goods Sold will be higher. It is my understanding that once you commit to a particular inventory methodolgy(LIFO, FIFO, Average) you are committed to that valuation system for at least 5 years.