What Is the Difference Between a Specific Identification Inventory & an FIFO Inventory?
To keep accurate books, a company has to know how much money it has tied up in inventory at any given time, and it must have a system for adjusting the value of its inventory when it sells items to customers. A specific identification inventory system treats each item individually, giving it a distinct value that it tracks from start to finish. A first-in, first-out, or FIFO, system treats individual items as interchangeable, but assigns them a bookkeeping value on their way out the door.
A company using the specific identification method keeps track of each item in its inventory individually. This system works for companies whose inventory consists of unique items with varying values. If you owned, say, a fruit stand, one Red Delicious apple is pretty much the same as the next one, so you wouldn’t have to keep track of the apples as individual inventory items. If you sold one, you’d just reduce the total cost of your inventory by the value of one apple. But if you owned an art dealership, the paintings might be distinctly different; how you’d adjust the value of your inventory depends on which particular painting you sold.
A specific identification inventory system tracks inventory with item identifiers, such as serial numbers or bar codes. The current value of the inventory is the sum total of the individual prices the company paid for each of the items in inventory. So if an art dealer has five paintings in inventory that were bought for, say, $250, $500, $2,000, $4,000 and $7,000, the value of the inventory on its balance sheet would be $13,750. When a sale occurs, the company reduces the inventory value by the distinct cost of the item sold. If it sold the $2,000 painting, it would list its current inventory as $11,750.
In a first-in, first-out inventory system, a company has many identical items in its inventory, but because it acquired them at different times from different suppliers, they may have been purchased for different prices. Think of a hardware store that has 100 identical screwdrivers in its inventory. It bought 20 of them in January for $2 apiece, 30 of them in March for $2.50 apiece, and 50 of them in June for $2.60 apiece. The total cost of the items in inventory is $245, or (20 x $2) + (30 x $2.50) + (50 x $2.60). When the company sells a screwdriver, though, it doesn’t matter which “batch” it comes out of, because they’re all the same. For accounting purposes, FIFO just assumes that screwdrivers get sold in the order they came in. The “first ones in” are the “first ones out.” In this case, the company would reduce its inventory by $2.
Alternatives to the FIFO method for inventories with identical items include the “last in, first out,” or LIFO, method and average-cost inventorying. In LIFO, the company attributes each sale to the most recently acquired inventory items and “works backward” toward the older items. In a LIFO system, the hardware store described earlier would reduce its inventory by $2.60 when it sold a screwdriver. In average-cost inventorying, the company averages out the cost of all items in its inventory. In the example, the store has 100 screwdrivers with a total inventory value of $245, so when it sold one, it would reduce its inventory by $2.45. The average would adjust as the store bought more screwdrivers at different prices.