Next In First Out

Key Takeaways

• NIFO bases inventory valuation on replacement cost rather than original cost.
• This method doesn't comply with GAAP due to its divergence from standard cost principles.
• Businesses may use NIFO internally during periods of inflation when replacement costs rise.
• NIFO can provide a practical valuation that reflects current business conditions.
• Companies' reporting can use LIFO or FIFO for audited financial statements.

What Is Next In, First Out (NIFO)?

Next In, First Out (NIFO) values inventory according to how much it costs to replace items rather than the original cost. To reflect actual business conditions, companies may use NIFO internally when inflation is a factor and replacement cost is higher than an item's original cost. NIFO does not conform to generally accepted accounting principles (GAAP).1

Why Use Next In, First Out (NIFO)?

Some companies use Next In, First Out when inflation is a factor. Companies will set a selling price on a replacement-cost basis and use this method as a way to price the items it sells.

Although NIFO doesn't conform to GAAP, many economists and business managers prefer the economic rationale behind the method. As a cost flow assumption technique, by stating that the cost assigned to a product is the cost required to replace it, NIFO can offer a more practical valuation method businesses will actually see during normal operations.

For example, the traditional methods of Last In, First Out (LIFO) and First In, First Out (FIFO) can become distorted during inflationary periods. Using accounting methods based on these principles during inflationary environments can mislead business managers. Hence, many businesses will use NIFO for internal purposes during these periods and report results using LIFO or FIFO on their audited financial statements.

Practical Example: NIFO in Action

Suppose a company sells a toy widget for $100. The original cost of the widget was $47, which would result in a reported profit of $53.

At the time of the sale, the replacement cost of the widget was $63. If the company were to charge $63 for the cost of goods sold under the NIFO concept, the reported profit would decline to $37.