Inventory Costing Considerations for Using FIFO Method

As the world adjusts to the “new normal,” it is likely that many companies have been impacted in some way by COVID-19. For manufacturers the impact might be in a number of areas, including product mix, supply chain, concessions in leases and capacity issues. These areas all have the potential to challenge some of the estimates that manufacturers use to calculate the net realizable value (NRV) of their inventory.

Capitalization of Variances

Initially, inventory is measured at cost, which in principle sounds simple, but some companies struggle with the determinations of cost. One challenging area is the capitalization of variances. For companies using a standard costing model, the capitalization of variances (sometimes called a claw back) at a period-end to reflect the actual cost of the inventory on hand may need to be revisited to the extent it is based on inventory turns or another metric that might have been disrupted and not consistent with historical patterns due to COVID-19.

Idle Facility/Reduced Capacity

Another area in which manufacturing companies struggle is how to account for idle or partially used space and capacity in their factories. Companies that shut down lines and operate at reduced capacity have to account for these costs.

Accounting Standard Codification (ASC) 330-30-3 discusses how both variable and fixed production costs are allocated. Variable costs are allocated to each unit of production on the basis of the actual use of the production facilities; and the allocation of fixed production overhead for the costs of conversion is based on the normal capacity of the production facilities. ASC 330-30-3 also states that “normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances.”

Most companies will determine “normal capacity” using a historical or “look back” model, looking at what the costs have been over time, thereby “averaging” pluses and minuses. However, the events of 2020 might have created some extreme minuses (or pluses) that might need to be considered to determine which costs are allocated and/or qualify as abnormal.

ASC 330-30-5 lists examples of factors that might be anticipated to cause an abnormally low production level, including significantly reduced demand, unplanned facility or equipment downtime.

ASC 330 permits a company to use the actual level of production if it approximates normal capacity. However, ASC 330 states that the amount of fixed overhead allocated to each unit of production shall not be increased as a result of abnormally low production or idle plant. In other words, if you have abnormal costs that essentially increase the cost of your inventory beyond normal, the excess costs should be considered a period cost and expensed.

Subsequent Measurement

ASC 275-10-05-7 acknowledges that “estimates inherent in the current financial reporting process inevitably involve assumptions about future events…For another example, carrying inventories measured using first-in, first-out (FIFO) at the lower of cost and net realizable value or market is based on an assumption that there will be sufficient demand for that product in the future to be able to sell the quantity on hand without incurring losses on the sales or, if net realizable value market is used, that it can be estimated. Making reliable estimates for those such matters is often difficult even in periods of economic stability; it is more so in periods of economic volatility.”

ASC 330 requires companies using FIFO to record their inventory at Net Realizable Value (NRV). As a result of this requirement, many companies record an Excess and Obsolete (E&O) reserve to their gross inventory balances, essentially acknowledging that some inventory will not ultimately be sold or used in the near term. In order to calculate the E&O reserve, many companies use simple ratios, such as how often inventory turns over and utilize a policy (formula) based on history to calculate the reserve for the inventory on hand at the end of a period. A simple, commonly used formula is a standard percentage based on the months of inventory on hand. For example, a company with six months of inventory on hand might reserve at 10 percent, 12 months of inventory on hand at 25 percent reserve and 24 months at 100 percent. Obviously, this calculation is based on inventory on hand and is likely developed over time based on historical trends and knowledge of the business. However, some companies should consider whether the facts and circumstances have changed as a result of the economic volatility. For example, a company having lower sales over the last nine months might now have more months of inventory on hand, resulting in a larger reserve, and hence larger expense. Imagine now if business increases in 2021 and inventory on hand is used. When the calculation is re-performed at the end of the next period, the reserve and expense could be reduced significantly, thereby providing potentially significant swings in the timing of expense.

A final issue companies should keep in mind as they make these adjustments is guidance issued by the U.S. Securities and Exchange Commission (SEC) in Staff Accounting Bulletin 5BB: “Based on FASB ASC paragraph 330-10-35-14, the staff believes that a write-down of inventory to the lower of cost or market (NRV) at the close of a fiscal period creates a new cost basis that subsequently cannot be marked up based on changes in underlying facts and circumstances.” While this guidance is for public companies, the treatment will likely be the same for private companies.

With companies revisiting many of the calculations and estimates in their inventory process, this may be a difficult year-end for many manufacturers, as conventional wisdom and history-based models are challenged. DHG can help answer your questions, so reach out to us for more information at


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