What Is the FIFO Method?
The First-In, First-Out (FIFO) method is an inventory accounting valuation approach that assumes the first goods purchased or produced by a company are the first ones sold or used. Within the broader field of financial accounting, FIFO is one of the most common methodologies used by businesses to manage their inventory and calculate the cost of goods sold (COGS). This method aligns with the natural flow of many businesses, especially those dealing with perishable goods or products with a limited shelf life, as it logically prioritizes the sale of older stock to prevent obsolescence or spoilage.
When a company uses the FIFO method, the costs associated with the oldest inventory items are expensed first, leaving the costs of the most recently acquired items in the remaining inventory balance. This valuation directly impacts a company's financial statements, including its income statement and balance sheet, influencing reported gross profit and net income.
History and Origin
The concept of matching the oldest costs with sales has been a foundational principle in inventory management. While no single "invention" date exists for the FIFO method, its formalization and widespread adoption are closely tied to the development of modern accounting standards. As businesses grew in complexity and inventory tracking became essential for financial reporting, various cost flow assumptions emerged.
Internationally, the FIFO method is explicitly permitted and widely used under International Financial Reporting Standards (IFRS). Specifically, IAS 2 Inventories, issued by the International Accounting Standards Board (IASB), outlines the acceptable methods for determining the cost of inventories, including FIFO and the weighted average cost method. The IASB revised IAS 2 in December 2003, making it effective for annual periods beginning on or after January 1, 2005. This revision notably removed the Last-In, First-Out (LIFO) method as an allowable inventory cost formula, citing its lack of representational faithfulness of inventory flows18, 19. In the United States, under Generally Accepted Accounting Principles (US GAAP), the FIFO method is also permitted, alongside LIFO and the weighted average method. The Financial Accounting Standards Board (FASB) provides guidance on inventory accounting primarily through ASC 330, Inventory, which states that the objective in selecting a method should be to choose the one that most clearly reflects periodic income16, 17.
Key Takeaways
- The FIFO method assumes that the first items of inventory purchased or produced are the first ones sold.
- This method generally aligns with the physical flow of goods for many businesses, especially those dealing with perishable or time-sensitive products.
- Under conditions of inflation, the FIFO method typically results in a lower cost of goods sold and a higher reported net income.
- The ending inventory value on the balance sheet under FIFO tends to reflect more recent costs, which can be closer to current market values.
- FIFO is permitted under both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP).
Formula and Calculation
The FIFO method is a cost flow assumption, meaning it dictates how costs are assigned to units sold and units remaining in inventory, rather than involving a single complex mathematical formula. The calculation involves tracking the cost of each batch of inventory purchased.
To calculate cost of goods sold (COGS) using FIFO, you identify the cost of the earliest units available for sale until all units sold are accounted for. The remaining units in inventory are then valued at the cost of the most recently purchased or produced goods.
Consider the following variables for inventory tracking:
- = Number of units purchased in batch 'n'
- = Cost per unit for batch 'n'
- = Total number of units sold during the period
- = Sum of beginning inventory units and all units purchased
The calculation process prioritizes the older costs:
This approach ensures that the cost assigned to the sold items truly reflects the cost of the first items that entered the inventory.
Interpreting the FIFO Method
Interpreting the results of the FIFO method primarily involves understanding its impact on a company's financial statements, particularly in varying economic conditions. When prices are rising (a period of inflation), FIFO generally results in a lower cost of goods sold because the older, less expensive inventory costs are expensed first14, 15. This leads to a higher reported gross profit and, consequently, a higher net income.
Conversely, in periods of falling prices, the FIFO method would lead to a higher COGS and lower reported profit. The valuation of ending inventory under FIFO tends to be closer to current replacement costs, as the remaining inventory is assumed to consist of the most recently purchased items12, 13. This can provide a more accurate representation of the current value of a company's asset on the balance sheet.
Hypothetical Example
Imagine "TechGadget Inc." sells a specific electronic component. Here's how the FIFO method would work for their inventory:
Beginning Inventory (January 1):
- 100 units @ $10.00 each = $1,000
Purchases:
- January 15: 50 units @ $11.00 each = $550
- January 25: 70 units @ $12.00 each = $840
Sales (January 31):
- 180 units sold
Let's calculate the Cost of Goods Sold (COGS) and ending inventory using the FIFO method:
Cost of Goods Sold (COGS):
Under FIFO, the first units in are the first units out.
- All 100 units from Beginning Inventory are sold: 100 units * $10.00 = $1,000
- All 50 units from January 15 purchase are sold: 50 units * $11.00 = $550
- Remaining units needed for sale: 180 (total sold) - 100 - 50 = 30 units. These come from the January 25 purchase: 30 units * $12.00 = $360
Total COGS = $1,000 + $550 + $360 = $1,910
Ending Inventory:
Total units purchased/available: 100 (beginning) + 50 + 70 = 220 units
Units sold: 180 units
Units remaining in inventory: 220 - 180 = 40 units
Since the newest units are assumed to remain in inventory:
The 40 remaining units are from the January 25 purchase: 40 units * $12.00 = $480
Therefore, under the FIFO method, TechGadget Inc. would report a COGS of $1,910 and an ending inventory value of $480 on its balance sheet.
Practical Applications
The FIFO method is widely applied across various industries and serves several key purposes in accounting and financial reporting. Many businesses, particularly those handling perishable goods like food, pharmaceuticals, or fashion items, naturally operate on a FIFO basis to minimize spoilage, obsolescence, and markdowns.
In financial analysis, understanding a company's use of the FIFO method is crucial for interpreting its financial statements. For instance, in an inflationary environment, a company using FIFO will report higher profits compared to one using alternative methods, which can impact profitability ratios and investor perception10, 11. This also has implications for tax liability, as higher reported profits can lead to higher taxes in such environments9.
Furthermore, regulatory bodies often specify acceptable inventory valuation methods. As noted, International Financial Reporting Standards (IFRS) specifically allow and widely support FIFO, which is a key reason many multinational corporations adopt it for consistency across global operations7, 8. This uniform application simplifies cross-border financial consolidation and reporting.
Limitations and Criticisms
While the FIFO method offers several advantages, it also has limitations and faces certain criticisms, particularly regarding its impact during periods of significant price changes.
One major criticism arises during inflationary periods. Because FIFO assumes the oldest, typically lower-cost items are sold first, it results in a lower cost of goods sold (COGS) and, consequently, a higher reported gross profit and net income5, 6. While this might seem beneficial, it can lead to a higher tax liability for the company, as its taxable income appears greater than if more recent, higher costs were matched against revenue4. Some critics argue that this overstates "real" profitability in an inflationary environment, as the reported profits might not be sufficient to replace the inventory at current, higher prices. The CFA Institute has noted that FIFO valuation during periods of high inflation can overstate reported earnings and taxes3.
Another limitation is that while FIFO often mirrors the actual physical flow of goods, particularly for perishable items, it may not reflect the actual flow for all businesses, especially those dealing with homogenous, non-perishable goods where inventory might be stacked or stored in a way that the latest items are picked first. Consistency in applying the chosen inventory accounting method is vital, as frequent changes can complicate financial reporting and obscure trends.
FIFO vs. LIFO Method
The FIFO (First-In, First-Out) method and the LIFO (Last-In, First-Out) method are two primary cost flow assumptions used in inventory accounting, often leading to significant differences in a company's financial statements. The core distinction lies in how each method assigns costs to the cost of goods sold (COGS) and ending inventory.
- FIFO Method: As discussed, FIFO assumes that the earliest purchased or produced items are the first ones sold. This generally aligns with the physical flow of goods for many businesses, such as those selling perishable items. In an inflationary environment, FIFO results in a lower COGS and higher reported gross profit and net income, as older, cheaper costs are expensed first. The ending inventory under FIFO reflects more recent costs.
- LIFO method: Conversely, LIFO assumes that the most recently purchased or produced items are the first ones sold. In an inflationary environment, LIFO leads to a higher COGS because the most recent, higher costs are expensed first2. This results in lower reported gross profit and net income, which can translate to a lower tax liability. However, the ending inventory under LIFO is valued at older, potentially outdated costs.
A key point of confusion often arises because while FIFO frequently matches the actual physical flow of goods, LIFO rarely does. Despite this, LIFO has historically been favored by some U.S. companies during inflationary periods for the tax benefits it offers due to lower taxable income. However, LIFO is not permitted under International Financial Reporting Standards (IFRS)1.
FAQs
What kind of businesses commonly use the FIFO method?
Businesses that deal with perishable goods (like food products, flowers, or pharmaceuticals), products with expiry dates, or items that are subject to rapid technological obsolescence (like electronics) commonly use the FIFO method. This is because it naturally reflects the physical flow of these goods, ensuring that older stock is sold or used before it expires or becomes outdated.
How does the FIFO method affect a company's taxes?
In an environment of rising prices (inflation), the FIFO method generally results in a lower cost of goods sold and a higher reported net income. This higher reported income can lead to a greater tax liability for the company compared to other inventory valuation methods like LIFO, which would report lower profits during such periods.
Can a company switch from FIFO to another inventory method?
A company can generally switch its inventory accounting method, but accounting standards (accounting standards) require that such changes be justified and applied consistently. Changes are typically only allowed if they result in a more faithful representation of the company's financial position or performance. Any change must be disclosed in the financial statements, often with retrospective application to ensure comparability.
Is the FIFO method allowed under all accounting standards?
Yes, the FIFO method is widely accepted and permitted under both International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). IFRS specifically lists FIFO as one of the acceptable cost formulas for inventory valuation, alongside the weighted average cost method.