What is the FIFO Method?
FIFO, or “First In, First Out,” is an asset-management and valuation method where the earliest acquired or produced assets are sold, used, or disposed of first. Under FIFO, the assets with the oldest costs are included in the income statement’s Cost of Goods Sold (COGS). The remaining inventory aligns with the most recently purchased or produced items.
This method helps prevent obsolescence by selling the oldest inventory items first and maintaining the newest items in stock. While the actual flow of inventory does not have to follow this order, businesses must support why they chose this method for inventory valuation.
Key Takeaways
- FIFO is an accounting method where assets purchased or acquired first are disposed of first.
- First-In, First-Out (FIFO) assumes the remaining inventory includes items purchased last.
- LIFO, or Last-In, First-Out, is an alternative accounting method where assets purchased or acquired last are disposed of first.
- In inflationary markets, FIFO can result in a higher net income compared to LIFO due to lower, older costs being assigned to COGS.
How First In, First Out (FIFO) Works
FIFO serves cost flow assumption purposes. In manufacturing, as items progress through development stages and finished goods are sold, the associated costs are recognized as expenses. Under FIFO, the cost of the initially purchased inventory is recognized first.
The total inventory’s dollar value decreases as items are sold. Methods like FIFO help in calculating the associated costs. Typically, in inflationary markets, assigning older costs to COGS means older items may cost less than those purchased at current prices, resulting in lower expenses and higher net income.
Some companies align their inventory valuation method with how their inventory moves. For instance, grocers often sell older inventory items first.
Enhanced FIFO Example
Imagine a company purchases 50 widgets at $20 each, then buys another 50 widgets at $30 each. The company sells 40 widgets under FIFO. The COGS would be $20 per unit for the first 40 units because these were purchased initially. With 60 widgets remaining, the value of 10 of these items is still $20/unit, while the value of the other 50 items is $30/unit.
The company then sells 30 more widgets. The COGS for the next 10 sold would be $20 per unit, completely utilizing the older stock. The remaining 20 sold would be valued at $30 each, aligning with the latest purchase price. The 30 remaining widgets would each value at $30.
FIFO vs. LIFO
The alternative to FIFO is LIFO—Last In, First Out. This means the last item bought is sold first. In inflationary environments, LIFO results in lower net income and less ending inventory compared to FIFO. Higher costs are associated with recently inflated prices leading to higher COGS.
On the balance sheet, FIFO often results in higher inventory value and higher net income compared to LIFO, as more expensive inventory items are kept longer under FIFO. Note that LIFO is not permitted under International Financial Reporting Standards.
Other Valuation Methods
- Average Cost Inventory: Assigns the same cost to each item, averaging the total costs of goods in inventory by the number of items available.
- Specific Inventory Tracing: Used when every component of a finished product is known. If all pieces are not identifiable, FIFO, LIFO, or average cost methods are used.
Advantages and Disadvantages
Advantages
- Easier to understand and implement.
- Follows the natural inventory flow.
- Provides more accurate reflection of the current value of inventory.
- Necessary in some jurisdictions.
Disadvantages
- Can overstate profits, increasing the gap between costs and earnings.
- Higher income taxes in comparison to LIFO.
- May not accurately reflect inventory flow in innovative industries.
Why Choose the FIFO Method?
FIFO is popular globally for inventory valuation. It aligns expected cost flow with actual goods flow, accurately mirroring inventory costs. FIFO minimizes the impact of inflation by accounting for the price of older inventory over newer, often costlier, inventory.
Inventory Valuation Alternatives
Apart from FIFO, companies may use LIFO (opposite of FIFO), or Average Cost Inventory, providing a middle-ground for net income and balances. Specific Inventory Tracing is another method, suited when components of a finished product can be tracked entirely.
How to Calculate FIFO
Calculating FIFO involves adding the costs of the earliest inventory items sold. For 10 units sold, add the cost of the first ten items bought—this total becomes the cost of goods sold. The valuation method influences these costs.
The Bottom Line
FIFO method assumes assets are sold in chronological purchasing order. Mandatory in some regions, its ease and transparency make it a favorite in others. FIFO aligns well with actual cost flows, showcasing its utility in various business practices.
Related Terms: LIFO method, Average Cost Inventory, Specific Inventory Tracing, Inventory Valuation.
References
- Internal Revenue Service. “Publication 538, Accounting Periods and Methods”.
- American Institute of Certified Public Accountants. “Is IFRS That Different From U.S. GAAP?”
