Fifo first in first out

What Is FIFO First-In, First-Out?

FIFO, standing for "First-In, First-Out," is an inventory accounting method that assumes the first goods purchased or produced are the first ones sold. This method assigns the costs of the oldest inventory to the cost of goods sold (COGS) on a company's income statement. Consequently, the remaining inventory on the balance sheet is valued at the most recent costs. FIFO is a widely used approach within the broader field of inventory accounting because it generally aligns with the physical flow of most goods, especially perishable items or those with expiration dates.

History and Origin

The concept of matching costs with revenues has been a fundamental principle in accounting for centuries, though formal inventory costing methods like FIFO gained prominence with the standardization of financial reporting. In the United States, the need for consistent and transparent financial practices became particularly evident after the stock market crash of 1929. This event spurred the establishment of regulatory bodies like the Securities and Exchange Commission (SEC) in 1934, which, in turn, delegated the responsibility for setting accounting standards to private-sector organizations.¹⁶, ¹⁷

This ultimately led to the development and evolution of Generally Accepted Accounting Principles (GAAP) in the U.S., with the Financial Accounting Standards Board (FASB) becoming the primary standard-setter in 1973.¹⁵ Within GAAP, FIFO has long been an acceptable method for valuing inventory, alongside other methods.¹⁴ Its intuitive nature, reflecting the natural flow of goods, likely contributed to its early and sustained adoption in financial reporting. The FASB continues to issue and update guidance related to inventory, such as Topic 330 in its Accounting Standards Codification, which outlines the principles for inventory measurement and disclosure.¹³

Key Takeaways

• Cost Flow Assumption: FIFO assumes that the oldest units of inventory are the first ones sold, regardless of the actual physical flow of goods.
• Impact on Financial Statements: During periods of inflation, FIFO typically results in a lower cost of goods sold, leading to higher reported gross profit and net income.
• Balance Sheet Valuation: Under FIFO, the ending inventory value on the balance sheet reflects the most recent costs, which tends to be closer to current market values during inflationary periods.
• Global Acceptance: FIFO is permitted under both U.S. GAAP and International Financial Reporting Standards (IFRS), making it a common method for companies operating internationally.¹²
• Tax Implications: In an inflationary environment, the higher reported net income under FIFO can lead to a higher tax liability for businesses.

Formula and Calculation

The FIFO method does not use a single "formula" in the traditional sense, but rather a calculation process to determine the cost of goods sold and the value of ending inventory. The core principle involves assigning costs in the order they were incurred.

To calculate COGS and ending inventory using FIFO, follow these steps:

1. Identify Units Sold: Determine the total number of units sold during the period.
2. Cost the First Units In: Assign the costs of the oldest available inventory units to the units sold until all units sold are accounted for.
3. Calculate COGS: Sum the costs assigned in step 2.
4. Identify Units in Ending Inventory: Determine the remaining units after sales.
5. Cost the Last Units In: Assign the costs of the most recently purchased (or produced) units to the ending inventory.
6. Calculate Ending Inventory Value: Sum the costs assigned in step 5.

Example Calculation:

Consider a company, "TechGadget Inc.," that sells electronic accessories. Here are its inventory purchases for the month:

• January 1: Beginning Inventory – 100 units @ $10 each
• January 10: Purchase 1 – 150 units @ $12 each
• January 20: Purchase 2 – 200 units @ $13 each

During January, TechGadget Inc. sells 300 units.

Step 1: Calculate Cost of Goods Sold (COGS) using FIFO

Under FIFO, the first units acquired are considered sold first.

Step 2: Calculate Ending Inventory using FIFO

The ending inventory consists of the remaining units, which are the most recently purchased ones.

Total units available for sale = 100 (BI) + 150 (P1) + 200 (P2) = 450 units
Units sold = 300 units
Units in ending inventory = 450 - 300 = 150 units

So, under the FIFO method, the cost of goods sold for January is $3,450, and the ending inventory is valued at $1,950.

Interpreting the FIFO Method

The interpretation of financial results when using the FIFO method is heavily influenced by economic conditions. During periods of inflation, where costs are generally rising, FIFO results in a lower COGS because it matches older, lower costs against current revenues. This leads to a higher reported gross profit and ultimately a higher net income. Conversely, the ending inventory on the balance sheet is valued at more recent, higher costs, providing a valuation that more closely reflects current market values of assets.

In periods of deflation, where costs are falling, the effects are reversed. FIFO would result in a higher COGS (using older, higher costs) and thus a lower reported net income. The ending inventory would still be valued at the most recent costs, which would be lower. It is crucial for users of financial statements to understand the inventory costing method a company uses, as it significantly impacts profitability metrics and asset valuation.

Hypothetical Example

Imagine "FreshBake Bakery," which purchases flour regularly. To ensure freshness, they physically use the oldest bags of flour first. This physical flow naturally aligns with the FIFO accounting method.

On March 1, FreshBake had 50 bags of flour in inventory, purchased at $10 per bag.
On March 5, they bought 100 bags at $11 per bag.
On March 15, they bought another 75 bags at $12 per bag.

During March, FreshBake Bakery used 180 bags of flour.

To calculate the cost of goods sold using FIFO:

1. The first 50 bags used are from the March 1 beginning inventory: 50 bags * $10/bag = $500.
2. The next 100 bags used are from the March 5 purchase: 100 bags * $11/bag = $1,100.
3. FreshBake still needs to account for 30 more bags (180 total used - 50 from beginning inventory - 100 from March 5 purchase = 30). These 30 bags come from the March 15 purchase: 30 bags * $12/bag = $360.

Therefore, the total cost of flour used (COGS) for March is $500 + $1,100 + $360 = $1,960.

The remaining inventory would be 45 bags from the most recent purchase (75 bags purchased on March 15 - 30 bags used = 45 bags), valued at 45 bags * $12/bag = $540.

Practical Applications

FIFO is extensively applied in various facets of finance and accounting:

• Inventory Management: For businesses, particularly those dealing with perishable goods (food, pharmaceuticals) or fashion items, FIFO often mirrors the actual physical flow of inventory. This alignment helps manage product freshness, obsolescence, and quality control.
• Financial Reporting: The FIFO method is a primary choice for valuing inventory and calculating cost of goods sold for financial statements. It is permitted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it a globally accepted accounting standard. Compa¹¹nies often choose FIFO because, during inflationary periods, it presents a higher net income and an ending inventory value that is closer to current replacement costs, which some stakeholders may view as a more realistic representation of the company's financial position.
• Investment Cost Basis Calculation: For individual investors, the Internal Revenue Service (IRS) defaults to the FIFO method when determining the cost basis of shares sold if the investor does not specifically identify which shares were sold. This ⁸, ⁹, ¹⁰means the first shares acquired are assumed to be the first ones sold, which impacts the calculation of capital gains or losses for tax purposes. This can significantly affect an investor's tax liability, especially for long-term investments. The IRS provides specific guidance on how to compute the cost basis for investments, including those acquired through dividend reinvestment plans.
• ⁷Performance Analysis: Analysts use a company's chosen inventory method to interpret its profitability. Understanding how FIFO impacts COGS and gross profit allows for more accurate comparisons between companies using different accounting standards or operating in different economic climates.

Limitations and Criticisms

While widely used, FIFO is not without its limitations, particularly in certain economic environments:

• Impact on Profitability During Inflation: During periods of sustained inflation, the FIFO method matches older, lower costs against current revenues. This results in a higher reported gross profit and net income. While this might seem beneficial for the income statement, it can lead to "inventory profits" that are not sustainable, as the company will eventually have to replace its inventory at higher current costs. This ⁵, ⁶can also lead to a higher tax liability because reported taxable income is greater.
• ⁴Mismatch of Current Costs and Revenues (in Inflation): A common criticism is that FIFO does not provide the best matching of current costs with current revenues during inflationary periods. By using older costs for COGS, the reported profit margin might not accurately reflect the current profitability of operations, as the cost to replace the sold goods is higher than the cost expensed.
• Potential for Distorted Financial Ratios: The higher reported net income under FIFO during inflation can influence various financial ratios, such as profit margins and return on assets. Investors and creditors analyzing a company's financial statements must be aware of the inventory method used to avoid misinterpreting these metrics.
• Does Not Always Reflect Physical Flow: While often aligned with physical flow for perishable goods, FIFO may not reflect the actual physical movement of goods for all businesses, especially those dealing with fungible (interchangeable) products where newer items might be picked first from a stack or bin.

FIFO vs. LIFO

FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are two fundamental inventory costing methods that assume different flows of costs through a business. The primary distinction lies in which costs are expensed as cost of goods sold (COGS) and which remain in ending inventory on the balance sheet.

The choice between FIFO and LIFO significantly impacts a company's reported financial statements, particularly in periods of inflation. LIFO, by expensing the most recent, higher costs during inflation, leads to a lower taxable net income and thus a lower tax liability. Howev²er, this benefit comes at the cost of a lower reported inventory value on the balance sheet and is not allowed under IFRS, which can be a disadvantage for multinational companies.

F¹AQs

1. Why do companies choose the FIFO method?

Companies often choose the FIFO method because it is intuitive, assuming that the oldest items are sold first, which often aligns with the physical flow of goods, especially for perishable or time-sensitive products. It also results in an ending inventory value on the balance sheet that more closely reflects current market prices. This method is also universally accepted under major accounting standards like U.S. GAAP and IFRS.

2. How does FIFO affect a company's taxes?

In an inflationary environment, FIFO typically results in a lower cost of goods sold and, consequently, a higher reported net income. This higher net income can lead to a greater tax liability for the company, as more profit is subject to taxation. For investors, the IRS generally defaults to FIFO for calculating the cost basis of shares sold if no specific identification is made.

3. Is FIFO always the best method to use?

No, FIFO is not always the "best" method, as the optimal choice depends on a company's specific circumstances, industry, and the prevailing economic climate. While FIFO aligns with the physical flow of many goods and presents a balance sheet inventory value close to current costs, its impact on net income and tax liability during inflation can be a drawback for some businesses. Other methods, such as LIFO (not permitted under IFRS) or the weighted average cost method, might be more suitable depending on a company's objectives.