The first-in, first-out (FIFO) inventory cost method assumes the oldest inventory is sold first. This leads to minimizing taxes if the prices of inventory items are falling. In this situation, the prices of the items purchased first are higher because the prices are downward trending and hence the cost of the previously purchased items of inventory (i.e. the first inventory in) is higher. This results in a higher company's cost of goods sold (COGS). Last-in, first-out (LIFO) assumes the most recent inventory purchases are sold first.
Using the higher inventory costs (first in) would lead to a lower reported net income or profit for the accounting period (versus last out). As a result, the lower net income would mean the company would report a lower amount of profit used to calculate the amount of taxes owed.
Key Takeaways
- If a company uses the FIFO inventory method, the first items purchased and placed in inventory are the ones that were first sold.
- If the older inventory items were purchased when prices were higher, FIFO would lead to a higher cost of goods sold and lower net income when compared to LIFO.
- Lower net income would mean less taxable income and ultimately, a lower tax expense for that accounting period.
Understanding First-in, First-out (FIFO)
When companies generate their financial statements, they must calculate the revenue generated from sales, the costs that went into production (or COGS), and also the profit earned for that time period. A company would take the revenue total and subtract the inventory costs (as well as other expenses), to determine how much profit was earned.
Companies must determine which items in inventory were used up in generating the sales for that accounting period as well as the costs of those inventory items. If a company uses the FIFO inventory method, the first items that were purchased and placed in inventory are the ones that were first sold.As a result, the inventory items that were purchased first are recorded within the cost of goods sold, which is reported as an expense on the company's income statement.
In other words, with the FIFO method, the oldest inventory will be used in determining the cost of goods sold. When sales are recorded for the accounting period, the costs of the oldest inventory items are subtracted from revenue to calculate the profit from those sales.
First-in, First-out (FIFO) and Taxes
Although companies want to generate higher profits with each passing year, they also want to reduce their taxable income. If a company's inventory costs rose by 50%, for example, the company would report a lower amount for net income, assuming sales prices weren't increased to counter the higher inventory expense. A lower net income total would mean less taxable income and ultimately, a lower tax expense for the year.
The FIFO method can help lower taxes (compared to LIFO) when prices are falling. However, for the most part, prices tend to rise over the long term, meaning FIFO would produce a higher net income and tax bill over the long term.
If the older inventory items were purchased when prices were higher, using the FIFO method would benefit the company since the higher expense total for the cost of goods sold would reduce net income and taxable income. The newer, less expensive inventory would be used later, meaning the company would report a higher profit in later accounting periods and a higher taxable income—all else being equal.
Special Considerations
However, prices tend to rise over the long term, meaning that FIFO may not minimize taxes for a company. In a rising-price environment over the long term, the older inventory items would be the cheapest, while the newer, recently purchased inventory items would be more expensive.
FIFO would only minimize taxes in periods of declining prices since the older inventory items would be more expensive than the most recently purchased items. It's best to consult a tax professional before determining the best methods for reducing taxable income since there are many components that go into calculating a company's tax liability.
FAQs
The first-in, first-out (FIFO) inventory cost method assumes the oldest inventory is sold first. This leads to minimizing taxes if the prices of inventory items are falling.
What are the benefits of FIFO first in first out? ›
The FIFO method gives a very accurate picture of a company's finances. It is also the most accurate method of aligning the expected cost flow with the actual flow of goods which offers businesses a truer picture of inventory costs. This information helps a company plan for its future.
Which of the following is an advantage of the first in first out FIFO method? ›
Expert-Verified Answer. The advantage of the first in, first out FIFO method is that it reduces the risk of spoilage. Option B is correct. The FIFO method assumes that the first items that are purchased or produced are the first items sold or used, which means that the oldest inventory is always used first.
What is the FIFO method of income tax? ›
What Is the FIFO Method? FIFO means "First In, First Out" and is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first. FIFO assumes assets with the oldest costs are included in the income statement's Cost of Goods Sold (COGS).
What is a first in first out FIFO method? ›
First in, first out (FIFO) is an inventory method that assumes the first goods purchased are the first goods sold. This means that older inventory will get shipped out before newer inventory and the prices or values of each piece of inventory represents the most accurate estimation.
What are the advantages and disadvantages of the First In, First Out method? ›
While it has several advantages, the first-in, first-out (FIFO) accounting method has several drawbacks. In times of inflation, FIFO will show increased profits—though these may only be on paper. The inflated earnings that FIFO tends to show can result in a heavier tax burden for companies.
What are the advantages of FIFO work? ›
This career choice has become increasingly popular in Australia over the last couple of decades due to the high wages and attractive benefits FIFO workers receive.
- Pros of FIFO jobs. ...
- Freedom to live where you choose. ...
- Generous annual leave entitlements. ...
- Top-notch living facilities. ...
- Attractive pay and benefits.
Highest in, first out (HIFO) is a method of accounting for a firm's inventories wherein the highest cost items are the first to be taken out of stock. HIFO inventory helps a company decrease their taxable income since it will realize the highest cost of goods sold.
What is the principle behind First In, First Out FIFO? ›
FIFO stands for first in, first out, an easy-to-understand inventory valuation method that assumes that the first goods purchased or produced are sold first. In theory, this means the oldest inventory gets shipped out to customers before newer inventory.
Why is First In, First Out FIFO storage used? ›
FIFO helps food establishments cycle through their stock, keeping food fresher. This constant rotation helps prevent mold and pathogen growth. When employees monitor the time food spends in storage, they improve the safety and freshness of food. FIFO can help restaurants track how quickly their food stock is used.
First-in, first-out method (FIFO)
This means FIFO will generally result in higher capital gains being realized and potentially a larger tax liability. Also, FIFO doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Does FIFO minimize income tax liability? ›
The FIFO method can help lower taxes (compared to LIFO) when prices are falling. However, for the most part, prices tend to rise over the long term, meaning FIFO would produce a higher net income and tax bill over the long term.
Does the use of the FIFO method generally increases taxable income? ›
Tax and Cash Flow Implications
FIFO results in higher ending inventory values and higher net income. This increases taxable income and taxes owed. LIFO results in lower ending inventory on the books and lower net income. This reduces taxable income and income tax expenses.
What is the First In, First Out FIFO algorithm? ›
In summary, the FIFO algorithm works like a line or queue, where the first process in is the first one out. The OS uses a queue data structure to keep track of the order of the processes waiting to use a resource and uses enqueue and dequeue operations to add and remove processes from the queue.
What is an example of First In, First Out in real life? ›
Examples of FIFO queuing in real life
Most queues that we encounter throughout the day are FIFO queues. Waiting for the bus, waiting in front of the elevator or a vending machine, or even standing in line to the bathroom all share one quality — the person standing in the front goes before the one standing behind.
What is a First In, First Out FIFO data structure? ›
In computing and in systems theory, first in, first out (the first in is the first out), acronymized as FIFO, is a method for organizing the manipulation of a data structure (often, specifically a data buffer) where the oldest (first) entry, or "head" of the queue, is processed first.
What are the advantages of the LIFO method? ›
Benefits of LIFO
The most noteworthy advantages of LIFO include: Tax savings. If the cost of your products increases over time, the LIFO method can help you save on taxes. This is because applying the most recent or higher inventory costs to the items you've sold will cause your profit margin to go down.
What are the pros and cons of LIFO and FIFO? ›
After looking at the FIFO and LIFO difference, both methods have pros and cons. FIFO focuses on using up old stock first, whilst LIFO uses the newest stock available. LIFO helps keep tax payments down, but FIFO is much less complicated and easier to work with.
Why is first in first out FIFO storage used? ›
FIFO helps food establishments cycle through their stock, keeping food fresher. This constant rotation helps prevent mold and pathogen growth. When employees monitor the time food spends in storage, they improve the safety and freshness of food. FIFO can help restaurants track how quickly their food stock is used.
What are the advantages and disadvantages of the AVCO method? ›
Advantages & Disadvantages of the AVCO Method
| ADVANTAGES | DISADVANTAGES |
|---|
| It evens out fluctuations in unit price | The average unit cost may not reflect current costs |
| It is easier than FIFO and LIFO | It is suitable only for identical items |
3 more rows