Fifo

What Is FIFO?

FIFO, which stands for "First-In, First-Out," is a widely used inventory valuation method within the realm of accounting. This method assumes that the first goods purchased or produced by a business are the first ones to be sold, consumed, or otherwise disposed of. Consequently, the costs associated with the oldest inventory items are the first ones expensed as the cost of goods sold (COGS). While FIFO is an assumption for cost flow, it often aligns with the actual physical flow of goods, particularly for perishable items or those with limited shelf lives, making it a logical and intuitive approach for many businesses.

History and Origin

The concept of matching costs to revenues has been a fundamental principle in accounting for centuries. As businesses grew and managed larger inventories, the need for systematic methods to value these assets became critical. While the precise origin of the "First-In, First-Out" methodology is not attributed to a single inventor or moment, its adoption became prevalent as standardized accounting practices evolved. The development of accounting standards, such as those set by the Financial Accounting Standards Board (FASB) in the United States and the International Financial Reporting Standards (IFRS) globally, solidified FIFO's role as a recognized inventory valuation method.

For entities operating under U.S. Generally Accepted Accounting Principles (GAAP), the FASB has continuously refined guidance on inventory measurement. For example, Accounting Standards Update (ASU) 2015-11, issued by the FASB, simplified the subsequent measurement of inventory for companies using FIFO or the average cost method, requiring them to measure inventory at the lower of cost and net realizable value instead of the lower of cost or market.¹¹ Similarly, the International Financial Reporting Standards (IFRS), specifically IAS 2 Inventories, also provides guidance on cost formulas, permitting the use of FIFO for interchangeable items.¹⁰

Key Takeaways

• Cost Flow Assumption: FIFO assumes that the earliest purchased inventory items are the first ones sold.
• Balance Sheet Impact: Under FIFO, the ending inventory on the balance sheet reflects the most recent costs, which generally provides a more accurate representation of current inventory values, especially in an inflationary environment.
• Income Statement Impact: In periods of rising costs or inflation, FIFO typically results in a lower cost of goods sold and, consequently, a higher gross profit and net income on the income statement.
• Global Acceptance: FIFO is widely accepted under both GAAP and IFRS, making it a common choice for multinational corporations.
• Physical Flow Alignment: For many businesses, particularly those dealing with perishable goods, FIFO mirrors the actual physical movement of their inventory.

Formula and Calculation

The FIFO method does not involve a complex formula in the traditional mathematical sense but rather a cost flow assumption applied during calculations. When items are sold, their cost is assigned based on the order of their purchase.

To calculate the cost of goods sold (COGS) and ending inventory using FIFO, you typically track inventory purchases in layers:

[
\text{Cost of Goods Sold} = \text{Cost of Oldest Units Sold}
]

[
\text{Ending Inventory} = \text{Cost of Most Recent Units Remaining}
]

For example, if a company purchases units at different prices over time, under FIFO, the cost of the units sold will always be taken from the earliest available purchases. The remaining units in inventory will then be valued at the cost of the most recent purchases.

Interpreting the FIFO Method

Interpreting the FIFO method involves understanding its impact on a company's financial statements. Because FIFO assumes the oldest costs are expensed first, it can significantly affect reported profitability, especially in fluctuating economic conditions.

In an inflationary environment, where costs generally rise over time, FIFO results in lower COGS because it matches older, typically lower, costs against current revenues. This leads to higher reported gross profit and net income. Conversely, the ending inventory balance under FIFO will be valued at the more recent, higher costs, providing a more up-to-date representation of the asset on the balance sheet. This can be beneficial for a company's perceived financial health, as it shows a higher valuation of current assets.

However, this higher reported profit during inflation can also lead to higher tax liabilities. Economists sometimes refer to the higher profits under FIFO during inflationary periods as "illusory profits" because the company will need to replace the sold goods at higher current costs, which may not be fully reflected in the reported COGS.

Hypothetical Example

Consider a small electronics retailer, "TechGadget Inc.," that sells a popular smart device.

• January 1: TechGadget Inc. has a beginning inventory of 10 units purchased at $100 each.
• January 10: Purchases 20 units at $110 each.
• January 20: Purchases 15 units at $120 each.
• January 25: Sells 30 units during the month.

To calculate the cost of goods sold using FIFO:

1. The first 10 units sold are from the January 1 beginning inventory: 10 units * $100/unit = $1,000.
2. The next 20 units sold are from the January 10 purchase: 20 units * $110/unit = $2,200.

Therefore, the total cost of goods sold for January is $1,000 + $2,200 = $3,200.

To calculate the ending inventory:

• Total units purchased/available: 10 (beginning) + 20 (Jan 10) + 15 (Jan 20) = 45 units.
• Units sold: 30 units.
• Ending inventory units: 45 - 30 = 15 units.

Since the oldest units were sold first, the 15 units remaining in inventory are from the most recent purchase on January 20.

• Ending inventory value: 15 units * $120/unit = $1,800.

This example illustrates how FIFO systematically depletes the oldest costs first, leaving the most recent costs in the ending inventory.

Practical Applications

FIFO is a practical and widely adopted inventory accounting method across various industries. Its alignment with the actual physical flow of goods for many businesses makes it particularly suitable for certain sectors.

• Perishable Goods: Industries dealing with perishable products like food and beverages, pharmaceuticals, or cosmetics frequently use FIFO. This ensures that older stock is sold first to minimize spoilage and waste, and the accounting method reflects this operational reality.
• High-Turnover Inventory: Businesses with high inventory turnover, such as retail and fashion, often find FIFO appropriate. It ensures that the costs of items moving quickly off the shelves are recognized in a way that reflects their timely sale.
• Manufacturing: In manufacturing, FIFO helps track the cost of raw materials and work-in-process through production stages. By assuming older materials are used first, it provides a consistent framework for valuing manufacturing costs and helps in managing potential obsolescence of components.⁹
• Financial Reporting and Comparability: As FIFO is accepted under both GAAP and IFRS, it is often favored by multinational corporations seeking to simplify their accounting across different jurisdictions. This global acceptance enhances the comparability of financial statements for investors and analysts worldwide.,⁸

During periods of high inflation, some U.S. companies have even switched from LIFO to FIFO to align their inventory accounting with global operations and potentially boost reported profitability, as older, lower-cost inventory is expensed first.⁷

Limitations and Criticisms

While FIFO offers several advantages, it also has limitations and faces criticisms, particularly concerning its impact on financial reporting during specific economic conditions.

One significant criticism of FIFO arises during periods of sustained inflation. As older, lower costs are recognized in the cost of goods sold, FIFO tends to report higher gross profit and net income.⁶ This can lead to a higher tax burden for the company, as taxable income appears greater. Furthermore, the higher reported profits under FIFO in an inflationary environment may not accurately reflect a company's ability to replace its sold inventory at current market prices. This phenomenon is sometimes referred to as "phantom profits" or "illusory profits" because the company's real purchasing power for replacement inventory might be eroded.⁵

Another limitation is that while FIFO often aligns with the physical flow of goods for many businesses, it may not perfectly match the actual cost flow for all industries. For companies where newer items are consumed or sold first (e.g., in certain storage or bulk material industries), applying FIFO as a cost flow assumption might not accurately reflect their operational reality, even though it's permitted for accounting purposes.

Finally, while FIFO presents a more current value for inventory on the balance sheet, the income statement may show a less accurate matching of current revenues with current costs, as it uses older costs for the COGS. This can sometimes obscure the true economic performance of the company in the short term, especially in volatile markets.

FIFO vs. LIFO

FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are two primary inventory valuation methods that significantly impact a company's reported financial results. The fundamental difference lies in their assumptions about which inventory costs are expensed first when goods are sold.

Confusion between FIFO and LIFO often arises from their opposing effects on the income statement and balance sheet, particularly during periods of inflation. While FIFO can lead to higher reported profits, LIFO is often chosen in the U.S. for its potential tax advantages during rising prices, as it results in a higher COGS and thus lower taxable income.³

FAQs

What type of businesses typically use the FIFO method?

Businesses that sell perishable goods (like food, flowers, or pharmaceuticals), fashion items, or technology products with rapid obsolescence often use the FIFO method. This is because selling the oldest items first helps reduce waste and ensures customers receive fresh or up-to-date products, aligning the accounting method with the physical inventory flow.

How does FIFO affect a company's taxes?

In an environment of rising costs or inflation, FIFO generally results in a lower cost of goods sold and a higher reported net income. A higher net income typically translates to higher taxable income, which means the company may pay more in income taxes compared to using an alternative method like LIFO.

Is FIFO mandatory for any businesses?

While not universally mandatory, FIFO is a widely accepted and often preferred method globally. Many companies choose FIFO because it frequently aligns with the actual physical flow of their goods and is accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). IFRS prohibits the use of LIFO, making FIFO the common choice for companies operating under IFRS.²,¹

What is the primary benefit of using FIFO?

The primary benefit of FIFO is that it generally provides a more accurate representation of the current value of inventory on the balance sheet because the remaining inventory is valued at the most recent costs. It also often matches the actual physical flow of goods, particularly for perishable items, making it straightforward to implement and understand.