How Do You Calculate FIFO? AND LIFO( WITH EXAMPLES)

 FIFO stands for “First-In, First-Out”. It is a method used for cost flow assumption purposes in the cost of goods sold calculation. The FIFO method assumes that the oldest products in a company’s inventory have been sold first. The costs paid for those oldest products are the ones used in the calculation.

How Do You Calculate FIFO?

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.

The “inventory sold” refers to the cost of purchased goods (with the intention of reselling), or the cost of produced goods (which includes labor, material & manufacturing overhead costs).

Keep in mind that the prices paid by a company for its inventory often fluctuate. These fluctuating costs must be taken into account.

For instance, if a business sold 100 units of an item, and 75 units were originally purchased by the company at $10.00 and 25 units were purchased at $15.00, it cannot assign the $10.00 cost price to every unit sold. Only 75 units can be. The remaining 25 items must be assigned to the higher price, the $15.00.

Lastly, the product needs to have been sold to be used in the equation. You cannot apply unsold inventory to the cost of goods calculation.

The advantages to the FIFO method are as follows:

• The method is easy to understand, universally accepted and trusted.
• FIFO follows the natural flow of inventory (oldest products are sold first, with accounting going by those costs first). This makes bookkeeping easier with less chance of mistakes.
• Less waste (a company truly following the FIFO method will always be moving out the oldest inventory first).
• Remaining products in inventory will be a better reflection of market value (this is because products not sold have been built more recently).
• Higher profit.
• Financial statements are harder to manipulate.

The FIFO method gives a very accurate picture of a company’s finances. This information helps a company plan for its future.

What Are the Disadvantages of FIFO?

company also needs to be careful with the FIFO method in that it is not overstating profit. This can happen when product costs rise and those later numbers are used in the cost of goods calculation, instead of the actual costs.

FIFO EXAMPLE

Peter’s Sunglasses is a sunglass retailer located in London, UK. Peter opened the store in September of last year. Right now, it is just the one location but he may expand in the next couple of years depending on whether he can make good money or not.

January has come along and peter needs to calculate his cost of goods sold for the previous year, which he will do using the FIFO method.

Here is what his inventory costs are:

Month             Amount                   Price Paid

September      200 sunglasses      $200.00 per
October           275 sunglasses      $210.00 per
November      300 sunglasses       $225.00 per
December      500 sunglasses       $275.00 per

peter sold 600 sunglasses during this time, out of his stock of 1275..

Going by the FIFO method, Sal needs to go by the older costs (of acquiring his inventory) first.

Peter’s COGS calculation is as follows:
200 x $200.00 = $40,000.
275 x $210.00 = $57,750.
125 x $225.00 = $28,125.
COGS Total:   $125,875.

peter’s cost of goods sold is $125,875.

The remaining unsold 275 sunglasses will be accounted for in “inventory”.

Sal can use the cost of goods sold to help determine his profit.

Example  02

Going back to our retailer for example, let’s assume the five shirts that were purchased in May costs $7 per shirt. The shirts purchased in June cost $8.50 per shirt.

If the company sold 5 shirts for the year, Fifo would report costs of goods sold as $35 (5 shirts purchased in May at $7 per shirt). This FIFO cost does not take into full consideration the newer $8.50 per shirt cost of restocking the inventory. In fact, by the time to company will have to purchase more inventory the costs might go up even more than $8.50.

Thus, the FIFO method reports lower costs of goods sold on the income statement and tax return than the company actually incurred for the year. This is a common technique that management uses to increase reported probability. This reporting does have a downside, however. Lower costs and higher profit  translates in to higher levels or taxable income and more taxable due.

Example  03 ( this  example use for explain to LIFO method also.)

Bee’s Lighting buys and resells lamps. Here’s a look at what it’s been costing Bee to build up his inventory since his store opened:

Month	Amount	Price Paid
October	100 lamps	$50.00 per
November	100 lamps	$85.00 per
December	100 lamps	$100.00 per

Bet’s say on January 1st of the new year, Bee wants to calculate the cost of goods sold in the previous year. Lee has sold 80 lamps so far.

COGS calculation is as follows:

80 x $50.00 = $4000.

(Because Bee is going by the FIFO method, he is using the oldest cost of $50.00 per lamp in the calculation.)

How Do You Calculate LIFO?

To calculate COGS (Cost of Goods Sold) using the LIFO method, determine the cost of your most recent inventory. Multiply it by the amount of inventory sold.

As with FIFO, if the price to acquire the products in inventory fluctuate during the specific time period you are calculating COGS for, that has to be taken into account.

Here is  LIFO methods calculation (EXAMPLE 03)

It looks like Lee picked a bad time to get into the lamp business. The costs of buying lamps for his inventory went up dramatically during the fall, as demonstrated under ‘price paid’ per lamp in November and December. So, Lee decides to use the LIFO method, which means he will use the price it cost him to buy lamps in December.

COGS calculation is as follows:
80 x $100.00 = $8,000.
(Because Lee is going by the LIFO method, he is using the most recent cost of $100.00 per lamp in the calculation.)

Although using the LIFO method will cut into his profit, it also means that Bee will get a tax break. The 220 lamps Bee has not yet sold would still be considered inventory.

The difference between the LIFO and FIFO calculation is $4000. That difference is called the LIFO reserve. It is the amount by which a company’s taxable income has been deferred by using the LIFO method.

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Illustrative financial statements and profitability ratio ROCE analysis with examples

 ILLUSTRATIVE FINANCIAL STATEMENT

To illustrative the calculation of ratio, the following statement of financial position and statement of profit or lost figures will be used. we are using a separate statement of profit or lost for this example, as no items of other comprehensive income are involved.

                

PROFITABILITY RATIO      

In our  example, the company made a profit in both 2021 and 2020, and there was an increase in profit between one year and the next:

(a) of 52% before taxation

(b) of 39% after taxation

Profit before taxation is generally thought to be a better figure to use than profit after taxation. Because there might be unusual variation in the tax charge from year to year which would not affect the underlying profitability of the company's operations. 

Another profit figure that should be calculate is profit before interest and tax (PBIT) This  is the amount of profit that the company earned before having to pay interest to the providers of loan capital, such as loan notes and medium term bank loans, which will be shown in the statement   of financial position as non current liabilities. It is therefore calculate as profit before tax plus interest charge on long term finance.

.

Published  account do not always  give sufficient details on interest payable to determine how much is interest on long term finance . Will be assume in our example that the whole of the interest payable ($ 18,115,000-note 02) relates to Long term finance.

PBIT in our example is therefore

     

This shows a 46% growth between 2020 and 2021            

Return on capital employed(ROCE)    

 

It is impossible to assess profit or profit growth properly without relating them  to the amount of funds (capital) that were employed in making the profits. the most important profitability ratio is therefore return on capital employed  (ROCE).  Which states the profit as a percentage of the amount of capital employed.

ROCE               =  (Profit before interest and taxation / (total assets- current liabilities))100%     

Capital employed  = Shareholder's equity + non current liabilities

                                                         OR

                                  Total assets - current liabilities

The underlying principle is that we must compare like with like, and so if capital means

(Share  capital and reserves + non current liabilities and  debtor capital) 

Profit must mean the profit earned by all  this capital together this is PBIT , since interest is the return for loan capital.

In our example, capital employed is:

2021 $ 1,870,630 - $ 860,731  =$ 1,009,899

2020 $ 1,664,425 - $ 895,656  =$    768,769

The total are the total assets less current liabilities  figures 2021 and 2020 in the statement of financial

 position

ROCE    2021  _ $ 360,245 /  $ 1,009,899  = 35.7 %    

               2020 _ $ 247,011 /   $   768,769  = 32.1%

What does a company's ROCE tell us ? in effect, a ROCE of 35.7%  means that for every  $ 100 of capital invested in the company ,management  create  $ 35.7 of profits  therefore, ROCE is a measure to assess how well capital is used to generate profit.

what should we be looking for ? there are three comparison that can be made.

(a) The change in ROSCE from one year to the next can be examined . in this example there has been an increase in ROCE by about four percentage points from 2020level

(b) The ROCE being earned by other companies , if this information in available, can be compared with the ROCE of this company. Here the information is not available.

(c) A comparison of the ROCE with current market borrowing rates may be made

(01) What would be the cost of extra borrowing to the company if it needed more loans, and is it earning  a ROCE  that suggests it could make profits to make such borrowing worthwhile?

(02) Is the company making a ROCE that it is getting value for money from its current borrowings?

In this example , if we suppose that current market interest rates, say , for medium -term borrowing from banks , are around 10% then the company's actual ROCE  of 36% in 2021 would not seem law. on the country , it might seem high.

However it is easier to spot a law ROCE than a high one, because there is always a chance that the company's  non current assets, especially property, are undervalued in its statement of financial position, and  so the capital employed figure might be unrealistically law. if the company had earned a ROCE , not  of 36%, but of , say only 6% then its return would have been bellow current borrowing rates and so disappointingly low.

Return on equity

Return on equity(ROI) gives a more restricted view of capital than ROCE , but it is based onthe same principles.

ROE  = (Profit  after tax and preference dividend / Equity share holder's fund )x100%

In our example ,ROE is calculated as follows

ROE       2021  _       $ 267,930  /  $909,899 =29.4%

ROE       2020  _      $ 193,830   /  $ 668,769 = 29%

ROE  is not widely -used ratio, however, because there are more useful ratios that give an indication of the return to share holders, such as earning per share, dividend per share, dividend yield and earning yield, which are described later .

 

Analyzing profitability and return in more details: secondary ratio      

we often sub analyze ROCE , to find out more about why the ROCE is high or low or better or worse than last year. there are two factors that contribute towards a return on capital employed. Both related to sale revenue

(A) Profit margin . A company might makes a high or low profit margin on its sales. for example,a company that makes a profit of $ 25 per $ 100 of sales is making a bigger return on its revenue than another company making a profit of only $ 110 per $ 100 of sales

(B) Assets turnover .Assets turnover is measure of how  well the assets of a business are being used to generate sales. For example ,

if  two companies each have capital employed  of $100m and company A makes sales of $400m per annum whereas company B makes sales of only  $ 200m per annum,,  company A making a higher revenue from the same amount of assets(twice as much asset turnover as company B) and this will help A to make  a higher return on capital employed than B. Asset turnover is expressed as "x times" so that assets generate x times their value in annual  sales  here, company A's assets turnover is 4 times and B's  is 2 times  .

Profit margin and asset turnover together explain the ROCE  and if the ROCE is the primary profitability ratio ,these other two are the secondary ratios .

In this example, the company's improvement in ROCE  between 2020 and 2021 is attributable to a higher asset turnover. indeed the profit margin has fallen a little, but the higher asset turnover has more than compensated for this

it is also worth commenting on the change in sales revenue from one year  to the next . $1,900 m to $ 3,100 m  between 2020 and 2021. this is very strong  growth, and this is certainly one of the  most significant term in the statements profit loss and statement  of financial position.

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Financial Statement Analysis( Introduction)

 Introduction analysis involves appraising and communication the position, performance and prospects of a business based on given and prepared statement and ratios

The abillity to review, analyse and interpret a set of financial statements is a key skill for a financial accountant. Analysis may involve any or all of the following:

01.Vertical or horizontal trend analysis

02.common size analysis 

03.ratio analysis

01.Vertical or horizontal trend analysis

Trend  analysis involves comparing financial statements. vertical trend analysis is comparing financial statements of one company from one year  to the next horizontal analysis is comparing the financial statements of one company with those of an equivalent company in the same  period.

This type  of analysis involving comparison has drawback:

(a) The financial result of one year may be skewed by a significant event, making comparison with another year  less meaningful. for this reason  its more useful to perform vertical analysis over an extended period rather than  just two years.

(b)   An equivalent company  ie a company of a similar size  in the same industry may be difficult to find, and if one is found,its result for a particular  year may ,again , be skewed by a particular event.

02 common size analysis

Common size analysis again involves comparison-either of the same company in different priods or different companies in the same period.

In the case, however, comparison is not of the "RAW" numbers presented in the financial statements.

interred, a common base figures is adopted and amounts are expressed as a percentage of this base number. These  percentage are then compared A common base figure when  analyzing the statement of profit or loss is revenue.

EXAMPLES

The following example shows the results of one company for two years

                                                                            2020                % of                    2019        % of

                                                                            $"000            revenue                 $"000      revenue

Revenue                                                             100,000                                        90,000

Cost of sales                                                       (35,000)            35%                  (30,000)       33%

Gross profit                                                         65,000                                         60,000

Distribution costs                                                (20,000)            20%                 (16,000)       18%

Administrative expenses                                     (15,000)            15%                 (21,000)       23%

Operating profit                                                   30,000                                        23,000

Finance costs                                                        (5,000)              5%                    (3,000)        3%

Profit before tax                                                   25,000                                        20,000

Tax                                                                         (5,000)              5%                   (4,000)       4%

Retained profit                                                        20,000                                       16,000

As the revenue in the company has increased, it follows that costs might increase. Common size analysis helps to identify whether costs have increased proportionately. questions that might be asked as a result of performing this analysis are as follows.

( a) Why has cost of sales increased as a proportion of revenue ? have selling prices reduced while cost per unit  remain  the same  or have  costs increased?

(b) why have distribution cost increased as a proportion of revenue ? have cost  such as petrol increased or are proportionately more items being distributed(this would be the case  if prices have decreased)?

(c)There is a significant drop in the proportion of revenue spent on admin expenses .is there a one off item of income in2020 or a one -off expense in 2019 that has caused the change  ?

(d) Finance cost as a proportion of revenue have increased: the company appears to have borrowed money in the year.this has been employed in the business and resulted in increased revenue.

03. Ratio Analysis

Ratio analysis involves manipulating amounts in the financial statements to produce a ratio. this is than compared with the same ratio for any of:

The same company in a different year

A different company in the same year

Industry averages

Ratios can be grouped  in to five categories

01) Profitability

02) long-term solvency

03)short -term liquidity

04) Efficiency(turn over ratios)

05) Share holders investment ratios

For each of the categories of ratio, we will identify a number of standard measures or ratios that are normally calculated and generally accepted as meaningful indicators.

It must be stressed, however, that each individual business must be considered separately, and a ratio that is meaningful for  a manufacture company may be too mechanical when  working out ratios and constantly think about what you are trying to achieve.

It is also important to remember that ratio analysis on its own is not sufficient for interpreting company accounts, and that there are other items of information that should be looked at, for example 

Example

(a) The content of any accompanying commentary on the accounts and other statements

(b) The age and nature of the company's assets

(c) current and future developments in the company's markets, at home and overseas, recent acquisitions or disposals of a subsidiary by the company

(d) Unusual items separately disclosed in the financial statements

(e) Any other noticeable features of the report and accounts, such as events after the end of the reporting period, contingent liabilities, a qualified auditors 'report, the company's taxation position, and so on

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