What Does Highest In, First Out Mean?
Highest in, first out (HIFO) is an inventory distribution method in which the inventory with the highest cost of purchase is the first to be used or taken out of stock. This will impact the company's books such that for any given period of time, the inventory expense will be the highest possible for cost of goods sold (COGS) and ending inventory will be the lowest possible.
Understanding Highest In, First Out (HIFO)
Companies would likely choose to use the highest in, first out (HIFO) inventory method if they wanted to decrease their taxable income for a period of time. Because the inventory that is recorded as used up is always the most expensive inventory the company has (regardless of when the inventory was purchased), the company will always be recording maximum cost of goods sold.
Contrast this with other inventory recognition methods such as last in, first out (LIFO), in which the most recently purchased inventory is recorded as used first, or first in, first out (FIFO), in which the oldest inventory is recorded as used first. LIFO and FIFO are standard inventory accounting methods, but it is LIFO that is part of generally accepted accounting principles (GAAP); HIFO usage is rare to non-existent and is not recognized by GAAP. Companies may occasionally change their inventory methods in order to smooth their financial performance.
Some Highest In, First Out Implications
A company could decide to use the HIFO method to reduce taxable income, but there are some implications. First, because it is not recognized by GAAP the company's books may come under greater scrutiny by auditors and result in an opinion other than an unqualified one. Second, in an inflationary environment, inventory that was taken in first may be subject to obsolescence. Third, net working capital would be reduced with lower value inventory. Last but not least, if the company relies on asset-based loans, lower inventory value will decrease the amount it is eligible to borrow.