Next in, first out definition

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What is Next In, First Out?

Next in, first out (NIFO) is a cost flow assumption, stating that the cost assigned to a product is the cost required to replace it. This concept is not allowed under any of the accounting frameworks (such as GAAP and IFRS), so it cannot be used in the preparation of financial statements that are supposed to be constructed under an accounting framework.

Advantages of Next In, First Out

There are some advantages associated with using a next in, first out system, which are as follows:

  • Eliminates inflation effects. The next in, first out concept is sometimes used for internal reporting purposes during periods of high inflation, so that management can see what the profit levels really should be, factoring in the effects of inflation. This information is then used to determine whether products should be discontinued or price points changed. In periods of high inflation, this approach is more practical than the first in, first out (FIFO) method, which reports the cost of goods sold using older inventory costs that may no longer be valid.

  • Can evaluate profitability. By using next in, first our costing, a business can evaluate whether the prices at which goods are currently being sold is sufficient to generate an adequate profit. If not, management may adjust its product pricing or decide to discontinue a product.

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Disadvantages of Next In, First Out

The key problem with NIFO is that it violates the cost principle, under which assets are supposed to be recorded at their original purchase costs. If replacement costs have changed significantly since the acquisition of an asset, the cost of goods sold could be significantly misstated under the NIFO concept, as would the reported profit level.

Example of Next In, First Out

As an example, a company sells a green widget for $100. The original cost of the widget was $58, which would result in a reported profit of $42. At the time of the sale, the replacement cost of the widget was $64. If the company were to charge $64 to the cost of goods sold under the NIFO concept, the reported profit would decline to $36.