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). The remaining inventory assets are matched to assets most recently purchased or produced.
The FIFO method avoids obsolescence by selling the oldest inventory items first and maintaining the newest items in inventory. The actual inventory valuation method used does not need to follow the actual flow of inventory through a company, but an entity must be able to support why it selected the inventory valuation method.
Key Takeaways
- FIFO is an accounting method in which assets purchased or acquired first are disposed of first.
- First In, First Out assumes that the remaining inventory consists of items purchased last.
- LIFO is an accounting method in which assets purchased or acquired last are disposed of first.
- In an inflationary market, lower, older costs are assigned to the cost of goods sold under the FIFO method, which results in a higher net income than if LIFO were used.
How First In, First Out Works
The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense. Under FIFO, the cost of inventory purchased first will be recognized first.
The dollar value of total inventory decreases in this process because inventory has been removed from the company’s ownership. The costs associated with the inventory may be calculated in several ways—one being the FIFO method.
Typical economic situations involve inflationary markets and rising prices. In this situation, if FIFO assigns the oldest costs to the cost of goods sold, these oldest costs will theoretically be priced lower than the most recent inventory purchased at current inflated prices. This lower expense results in higher net income. The ending inventory balance is inflated.
Companies choose which valuation method to use. Some companies may choose a method that mirrors their inventory. For example, a grocer often sells their oldest inventory first.
Example
Inventory is assigned costs as items are prepared for sale and based on the order in which the product was used. For FIFO, it is based on what arrived first.
Assume a company purchased 100 items for $10 each, then purchased 100 more items for $15 each. The company sold 60 items. Under the FIFO method, the COGS for each of the 60 items is $10/unit because the first goods purchased are the first goods sold. Of the 140 remaining items in inventory, the value of 40 items is $10/unit, and the value of 100 items is $15/unit because the inventory is assigned the most recent cost under the FIFO method.
With this remaining inventory of 140 units, the company sells an additional 50 items. The cost of goods sold for 40 of the items is $10, and the entire first order of 100 units has been fully sold. The other 10 units that are sold have a cost of $15 each, and the remaining 90 units in inventory are valued at $15 each, or the most recent price paid.
FIFO vs. LIFO
The inventory valuation method opposite to FIFO is LIFO, where the last item purchased or acquired is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory compared to FIFO. Instead of a company selling the first item in inventory, it sells the last. During periods of increasing prices, this means the inventory item sold is assessed a higher cost of goods sold under LIFO.
There are balance sheet implications between these two valuation methods. Because more expensive inventory items are usually sold under LIFO, the more expensive inventory items are kept as inventory on the balance sheet under FIFO. Not only is net income often higher under FIFO, but inventory is often larger as well.
LIFO is not permitted under International Financial Reporting Standards.
Other Valuation Methods
- Average Cost Inventory: The average cost inventory method assigns the same cost to each item. The average cost method is calculated by dividing the cost of goods in inventory by the total number of items available for sale. This results in net income and ending inventory balances between FIFO and LIFO.
- Specific Inventory Tracing: specific inventory tracing is used when all components attributable to a finished product are known. If all pieces are unknown, FIFO, LIFO, or average cost is appropriate.
Advantages and Disadvantages
The FIFO method is easy to understand and implement. Statements are more transparent, and it is harder to manipulate FIFO-based accounts to embellish the company's financials. FIFO is required under the International Financial Reporting Standards, and it is also standard in many other jurisdictions.
The FIFO method also follows the natural flow of inventory: most businesses prefer to sell their oldest products first. This also means that the company's accounts will better reflect the value of current inventory since the unsold products are also the newest ones.
However, there are some disadvantages. The FIFO method can result in higher income taxes for the company because there is a wider gap between costs and revenue. In jurisdictions that allow it, the alternate method of LIFO allows companies to list their most recent costs first. Because expenses rise over time, this can result in lower corporate taxes.
Pros
Easier to understand and implement.
Follows the natural flow of inventory.
Reflects the current value of inventory better than LIFO method.
Required in some jurisdictions.
Cons
Can overstate the company's profits, due to the gap between costs and revenue.
Company may end up with higher income taxes.
May not truly reflect the flow of inventory, especially for innovative industries
Why Is the FIFO Method Popular?
FIFO is the most widely used method of valuing inventory globally. It is also the most accurate method of aligning the expected cost flow with the actual flow of goods, which offers businesses an accurate picture of inventory costs. It reduces the impact of inflation, assuming that the cost of purchasing newer inventory will be higher than the purchasing cost of older inventory.
What Are the Other Inventory Valuation Methods?
The opposite of FIFO is LIFO (Last In, First Out), where the last item purchased or acquired is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory compared to FIFO. Average cost inventory is another method that assigns the same cost to each item and results in net income and ending inventory balances between FIFO and LIFO. Finally, specific inventory tracing is used only when all components attributable to a finished product are known.
How Is FIFO Calculated?
FIFO is calculated by adding the cost of the earliest inventory items sold. For example, if 10 units of inventory were sold, the price of the first ten items bought as inventory is added together. This equals the cost of goods sold. Depending on the valuation method chosen, the cost of these 10 items may differ.
The Bottom Line
The FIFO method, or First In, First Out, is a standard accounting practice that assumes that assets are sold in the same order they are bought. In some jurisdictions, all companies are required to use the FIFO method to account for inventory. But even where it is not mandated, FIFO is a popular standard due to its ease and transparency.
