Legal Definitions - next-in, first-out

Next-In, First-Out (NIFO)

NIFO, which stands for Next-In, First-Out, is a method used by businesses to estimate the value of the inventory they sell. Unlike most standard accounting practices that rely on the actual historical cost of goods, the NIFO method calculates the cost of goods sold based on what it would cost to replace those items at the time of sale, rather than their original purchase price. It essentially assumes that the next item to be acquired is the one being sold, and its hypothetical replacement cost is used for valuation. It's important to note that NIFO is generally not considered a Generally Accepted Accounting Principle (GAAP) for financial reporting.

• Example 1: A Retailer Facing Price Increases

  Imagine a small electronics store that sells a popular brand of headphones. They purchased their current stock of headphones for $100 each. However, due to supply chain issues, the manufacturer has announced a price increase, meaning the next batch of headphones the store orders will cost them $115 each.

  Using the NIFO method, when the store sells a pair of headphones from its existing stock, they would record the "cost of goods sold" as $115 (the anticipated replacement cost), not the $100 they actually paid for that specific pair. This illustrates NIFO because the valuation is based on the *next* expected cost to replenish inventory, rather than the *actual* historical cost of the item sold.

• Example 2: A Manufacturer with Fluctuating Raw Material Costs

  Consider a furniture maker who uses a specific type of wood. They bought a large shipment of this wood last month for $500 per unit. Today, due to market demand, the price for the same type of wood has risen to $550 per unit. The furniture maker is about to produce a new batch of chairs using the wood they already have in their workshop.

  If the furniture maker were to apply NIFO for valuing the wood component of the chairs they are producing and selling today, they would calculate the cost of the wood in each chair based on the *current replacement cost* of $550 per unit, even though they are using wood from the $500 shipment. This demonstrates NIFO in a manufacturing context, where the cost of raw materials used in production is valued at its immediate replacement cost, anticipating what it would cost to buy the next batch of materials.

• Example 3: A Company Trading in Commodities

  Suppose a company trades in agricultural commodities, such as coffee beans. They purchased a ton of coffee beans last week for $3,000. Today, due to weather conditions affecting harvests, the market price for a ton of coffee beans has increased to $3,200. The company then sells a ton of coffee beans from its existing inventory to a buyer.

  Under the NIFO method, when the company sells that ton of coffee beans, they would record its cost as $3,200 (the current market price to replace it), even though they originally acquired it for $3,000. This example highlights NIFO in a volatile market where replacement costs can change rapidly, as the valuation reflects the cost to acquire the "next" ton of coffee beans, rather than the historical cost of the specific ton sold.