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The first in, first out cost formula, better known as FIFO, assigns costs based on the cost flow assumption that inventory is used up or sold in the order in which it was purchased. Therefore, the costs associated with the earliestpurchases are assigned to the goods that are first used or sold. The costs associated with ending inventory are the most recent purchase costs.

For example, consider a merchandising company that makes purchases throughout the year of the following amounts. 

We also know the company had a beginning inventory of 200 units each worth $10.50, and an ending inventory of 250 units. To calculate the value of the ending inventory, we assume that 200 units are from the November 2nd order batch and 50 units are from the September 3rd order batch. 

We can then calculate the cost of goods sold by adding our purchases to our beginning inventory and subtracting this value of ending inventory. 

The FIFO cost flow assumption should be used when a firm typically sells its oldest inventory first. When this is the case, the FIFO method will reasonably approximate the specific unit cost method. At the same time, when a company adheres to the FIFO method, it prevents the manipulation of income because the costs that are charged to expenses each period must be determined the same way. Similarly, by valuing inventory based on the cost of the company's most recent purchases, the value of inventory under FIFO method closely resembles the actual replacement cost of inventory.

FIFOs basic disadvantage is that by valuing inventory at current prices, the value of cost of goods solds is based on the oldest costs. This may mean that current expenses are not matched against current revenues. This may distort gross profit and income, particulaly when prices are changing rapidly.   

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