Next-In First-Out (NIFO)
An inventory valuation technique in which the cost of the item is considered to be its replacement cost rather than its original cost
What Is Next-In First-Out (NIFO)?
Next-in, first-out is an inventory valuation technique in which the cost of the item is considered to be its replacement cost rather than its original cost.
This method of inventory valuation is not formed per the US Generally Accepted Accounting Principles (GAAP). Therefore, it breaches the costing principles and accounting concept of valuing inventory at the original cost rather than the current market value.
it is generally used by companies when there is too much inflation and the replacement cost is much greater than a product's original cost. In addition, many managers and economists prefer this because of the philosophy regarding the method, even if it does not conform to GAAP.
It offers a relatively more empirical method of valuing inventory which the company will comprehend during normal working operations by asserting that the replacement cost is the cost at which a product should be respected.
For example, during periods of high inflation, the use of first-in, first-out (FIFO) and last-in, first-out (LIFO) misrepresent the inventory levels and mislead managers to make wrong decisions about whether to reduce or increase production levels.
Therefore, for internal purposes, a company may prefer to use this method to value its inventory while reporting it through FIFO or LIFO in its annual reports.
For example, let's say there is company A, which sells smartphones for $100 each. If each unit's production cost were $60, it would result in a reported net profit of $40.
However, if NIFO is applied to the same situation, assuming the market value of the smartphone is $70, in such a case, the company will have to report $70 as the cost of goods sold and $30 as net profit.
NOTE
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Next-in, first-out (NIFO) is an inventory valuation method that considers replacement cost rather than original cost, deviating from GAAP.
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NIFO offers a practical approach to valuing inventory, emphasizing replacement cost as a more accurate measure during inflationary periods.
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Companies may use NIFO internally for decision-making but report using traditional methods externally, balancing practicality and compliance.
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NIFO can alter financial statements, providing a better estimate of inventory value during inflation but potentially misrepresenting cost of goods sold and profitability, especially with volatile replacement costs.
Other Inventory Valuation Methods
The methods through which inventory held by a company can be calculated at any particular time are called inventory valuation methods. The cost incurred by the company to acquire the raw materials and their processing is used to calculate inventory value.
The valuation method is crucial as it indirectly affects a company's income statement and balance sheet through the cost of goods sold (COGS).
1. First-In, First-Out Method (FIFO)
The FIFO method assumes that the goods arriving will be sold off first. Therefore, a company's balance sheet using the FIFO method is positively affected because this method provides better information regarding inventory valuation.
This happens because the cost of recently purchased goods would better resemble the inventory's current value. However, the profit and loss statement is negatively affected when using this method as the sales are compared with an out-of-date cost.
2. Last-In, First-Out Method (LIFO)
Under this method, it is assumed that the products received last will be the ones to be issued first. This method would be detrimental to a balance sheet as inventory is recorded at out-of-date costs.
However, using this method would increase the reliability and viability of the income statement as the sales will be matched to recent inventory costs. Therefore, this method is not accepted under the International Financial Reporting Standards (IFRS) and the Accounting Standards for Private Enterprises (ASPE). However, US GAAP allows the use of this method of inventory valuation.
3. Weighted Average Cost Method (WAC)
Under this method, all the goods are issued at the average price of inventory, i.e., the cost of goods available divided by the number of goods available for sale.
The weighted average cost method is acceptable under US GAAP, ASPE, and IFRS. However, this method would allocate the costs in a different way depending on whether the company uses a perpetual inventory system or a periodic inventory system.
Why doesn't GAAP allow the use of NIFO?
The next-in, first-out method to value inventory is not accepted under US GAAP as it can harm the quality and reliability of the financial statements.
A company operating in a sector in which prices are very volatile, the company can appear more profitable by deliberately selecting a replacement cost that is too low.
The aim of a company should always be to produce financial statements that present an accurate and fair picture of the company's financial health. However, NIFO's use can be ruinous for the financial reporting process.
Even though NIFO is not a universally accepted principle, it is used by many managers worldwide. This method is the most effective and correct during periods of high inflation as it allows the inventory to be priced at replacement cost.
This is necessary to enable the management to decide if a particular product's production should be continued or not. Thus, NIFO represents the inventory's market value.
In short, NIFO applies practically to several businesses and indicates a better estimate of inventory value in times of inflation.
Along with all the benefits that NIFO offers, the cost of goods sold and a company's profitability can be misrepresented by using this method in case replacement costs are volatile and are subject to change quickly.
Researched and authored by Kunal Goel | LinkedIn
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