How to calculate and record a FIFO adjustment in inventory accounting when your company
uses standard costing.
As discussed in the previous video on FIFO (which I would encourage you to watch first),
the acronym FIFO stands for First In First Out.
FIFO is an accounting fiction in cost accounting that is a major determinant of Cost Of Goods
Sold and Gross Profit.
We will use the exact same numbers in terms of the amount of product bought and sold as
in the previous video, but the value in $ will differ during the quarter.
In the first quarter of the year, Toy Giraffe Inc is building up its inventory.
In January, they buy 100 units at $5 per unit.
In February, 200 units at $6 per unit.
In March, another 100 units at $7 per unit.
The Q1 ending inventory is 400 units at a total purchase price of $2400,
so on average $6 per unit.
The cost accountant at Toy Giraffe Inc decides to use this average cost of $6 per unit as
the standard cost of the product for the automated journal entries that get booked when shipments
get registered in the ERP system.
The first box of toy giraffes (50 units) is sold in April.
The ending inventory is 7 boxes of 50 units each, 350 units in total.
Using standard costing, the inventory valuation for a month like April, when only a “soft
close” is performed, is very simple.
350 units in ending inventory at $6 per unit = $2100, 50 units in Revenue at $10 selling
price = $500, 50 units in Cost Of Goods Sold at $6 per unit = $300.
Gross Profit is $4 per unit, times 50 units is $200.
Two boxes of toy giraffes are sold in May.
The ending inventory is 5 boxes of 50 units each, 250 units in total.
Using standard cost, the ending inventory value is 250 units times $6 is $1500.
If we prepare the income statement for May, revenue is 100 units times $10 = $1000,
Cost Of Goods Sold (or COGS) is 100 units times $6 = $600,
and Gross Profit is 100 units times $4 = $400.
Four boxes of toy giraffes are sold in June.
The ending inventory is just 1 box of 50 units each.
In the preliminary steps of the quarter-end “hard close”, this inventory is valued
at the standard cost of $6 per unit.
50 times $6 is $300.
If we prepare the income statement for June, revenue is 200 units times $10 = $2000,
Cost Of Goods Sold (or COGS) is 200 units times $6 = $1200.
This is where a quarter-end “hard close” is different from a month-end “soft close”.
We look back at the Q1 purchase history, and find out that the 50 units that we have in
Q2 ending inventory, according to the FIFO (First In First Out) principle, are supposed
to originate from the March buy at $7.
So the Q2 ending inventory value needs to be adjusted to $7 FIFO value.
Here’s how to take care of the FIFO adjustment.
We take the preliminary June numbers, and add $50 to the inventory value as a FIFO adjustment:
$1 per unit to get from $6 standard cost to $7 FIFO cost.
An increase in inventory value on the balance sheet means an offsetting decrease in cost
in the income statement, negative $50 in Cost Of Goods Sold.
To summarize FIFO versus using standard cost with a FIFO adjustment, here are the Cost
Of Goods Sold and ending inventory values by period.
In the FIFO method, no COGS in Q1 as we did not sell anything, $250 in April, $550 in
May, $1250 in June, $2050 for all of Q2.
The ending inventory value is simply the previous period’s inventory value
minus this month’s COGS.
Start with $2400 at the end of Q1, then $2150 end of April,
$1600 end of May, $350 for end of June.
Starting and ending point when using standard cost with FIFO adjustment are the same, the
pattern over the months is different however.
$300 COGS in April, $600 in May, $1200 in June, plus quarter-end adjustment of minus
$50, $2050 for all of Q2.
The ending inventory value is simply the previous period’s inventory value
minus this month’s COGS.
Start with $2400 at the end of Q1, then $2100 end of April, $1500 end of May, $350 for end
of June after the FIFO adjustment.
In this example, COGS is higher and inventory value lower when using standard cost with
FIFO adjustment.
However, this all gets corrected at quarter end to land on the same total quarter numbers.
Thank you for watching!
The related videos on inventory accounting using the LIFO method, and the comparison
between FIFO and LIFO could also be useful for you.
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Thank you.