What Is the FIFO Method?
The First-In, First-Out (FIFO) method is an inventory valuation approach that assumes the first goods purchased or produced are the first ones sold, used, or otherwise disposed of. This method is a core concept within cost accounting and plays a significant role in determining a company's financial statements, particularly its income statement and balance sheet. The FIFO method typically aligns with the natural flow of goods for many businesses, especially those dealing with perishable items or products with expiration dates, as it prioritizes selling older stock to minimize obsolescence.40, 41
History and Origin
The need for systematic inventory valuation methods like FIFO arose with the increasing complexity of commerce and the formalization of accounting standards. As businesses grew and handled larger volumes of goods, it became impractical to track the specific cost of each individual item sold. Early accounting practices often relied on specific identification, but this became cumbersome for mass-produced or fungible goods. The development of cost flow assumptions, including the FIFO method, provided a standardized way to allocate costs.
Globally, the FIFO method is widely accepted and mandated by many accounting frameworks. For instance, it is permitted under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) used by many other countries.38, 39 The International Accounting Standards Board (IASB) and other regulatory bodies have sought to ensure consistency and comparability in financial reporting, which has favored methods like FIFO that often reflect the physical flow of goods.36, 37
Key Takeaways
- The FIFO method assumes that the oldest inventory items are sold first.
- It is a widely accepted inventory valuation method under both GAAP and IFRS.35
- During periods of inflation, FIFO generally results in a higher reported net income and higher ending inventory values.33, 34
- The FIFO method ensures that the remaining inventory on the balance sheet is valued at the most recent costs.32
- It often aligns with the actual physical flow of goods, particularly for perishable items.31
Formula and Calculation
The FIFO method does not involve a single formula but rather a cost flow assumption applied during calculations for Cost of Goods Sold (COGS) and ending inventory.
To calculate COGS using the FIFO method, costs are assigned to units sold based on the order in which they were acquired. The cost of the first units purchased or produced is expensed first.
To calculate ending inventory, the remaining units are valued at the cost of the most recently acquired units.
Consider a scenario where a company has the following inventory purchases:
- January 1: 100 units at $10 each
- January 15: 150 units at $12 each
- January 25: 200 units at $13 each
If the company sells 280 units during the period, the calculation using the FIFO method would be:
Cost of Goods Sold (COGS):
- 100 units from January 1 purchase (\times) $10/unit = $1,000
- 150 units from January 15 purchase (\times) $12/unit = $1,800
- 30 units from January 25 purchase (\times) $13/unit = $390
Total COGS = $1,000 + $1,800 + $390 = $3,190
Ending Inventory:
- The remaining units are 200 (total from Jan 25) - 30 (sold from Jan 25) = 170 units.
- 170 units from January 25 purchase (\times) $13/unit = $2,210
Total Ending Inventory = $2,210
This systematic approach ensures that the oldest costs are matched against revenues first.
Interpreting the FIFO Method
Interpreting the FIFO method involves understanding its impact on a company's financial metrics. Under FIFO, the inventory remaining on the balance sheet is valued using the most recent purchase prices, which generally provides a more up-to-date representation of the assets a company holds. This can be particularly advantageous for businesses with rapidly changing inventory values or those seeking to present a balance sheet that closely reflects current market conditions.30
Conversely, when prices are rising, the FIFO method will assign older, lower costs to the goods sold. This results in a lower Cost of Goods Sold and, consequently, a higher gross profit and taxable income compared to other methods during inflationary periods.29 For external users of financial statements, such as investors and creditors, the FIFO method can present a picture of higher profitability, which might influence their perception of the company's financial health.
Hypothetical Example
Imagine "EcoGear," a retailer selling reusable water bottles. They track their inventory using the FIFO method.
Here are EcoGear's inventory transactions for March:
- March 1: Beginning Inventory: 50 bottles at $5.00 each
- March 10: Purchase: 100 bottles at $5.50 each
- March 20: Sale: 80 bottles
- March 25: Purchase: 70 bottles at $6.00 each
- March 30: Sale: 100 bottles
Let's calculate the Cost of Goods Sold (COGS) and ending inventory for March using the FIFO method:
March 20 Sale (80 bottles):
- 50 bottles from March 1 (Beginning Inventory) @ $5.00 = $250
- 30 bottles from March 10 purchase @ $5.50 = $165
- Total COGS for March 20 sale = $415
Remaining inventory after March 20 sale:
- March 10 purchase: 100 - 30 = 70 bottles @ $5.50
- March 25 purchase: 70 bottles @ $6.00 (not yet purchased at this point, so 0 units)
March 30 Sale (100 bottles):
- 70 bottles from March 10 purchase @ $5.50 = $385
- 30 bottles from March 25 purchase @ $6.00 = $180
- Total COGS for March 30 sale = $565
Total Cost of Goods Sold for March:
- $415 (from March 20 sale) + $565 (from March 30 sale) = $980
Ending Inventory at March 31:
- The initial 70 bottles from the March 25 purchase (70 - 30 sold) = 40 bottles @ $6.00
- Total Ending Inventory = $240
In this example, the FIFO method systematically costs out the oldest units first, leaving the newest, more expensive units in the ending inventory balance.
Practical Applications
The FIFO method is widely applied across various industries, particularly where the physical flow of goods naturally follows a first-in, first-out sequence. This includes supermarkets, where perishable goods like dairy, produce, and baked goods must be sold quickly to prevent spoilage.28 Similarly, fashion retailers often use FIFO because older styles or seasonal items are typically discounted to make way for new collections.
In financial reporting, companies select an inventory costing method that best reflects their operations and provides a clear picture of their financial health. The FIFO method is particularly favored globally because it is permitted under both U.S. GAAP and IFRS, facilitating easier comparability across international borders where LIFO is often prohibited.26, 27 This consistency in accounting methods can be crucial for multinational corporations and investors analyzing companies in different regions.
Furthermore, the FIFO method can influence a company's profitability and taxable income, especially during periods of price changes. In an inflationary environment, where costs are generally rising, using FIFO results in a lower Cost of Goods Sold because it expenses older, cheaper inventory first. This leads to a higher reported gross profit and, consequently, higher reported earnings and potentially higher tax liabilities.25 Conversely, during periods of deflation, FIFO would result in a lower reported profit. Businesses must consider these implications when selecting and applying their inventory accounting methods, as such choices are subject to oversight by regulatory bodies like the IRS for tax purposes.24
Limitations and Criticisms
While the FIFO method is widely accepted and often mirrors the physical flow of goods, it has certain limitations, particularly concerning its impact on financial reporting during periods of significant price fluctuations.
One primary criticism is that during inflationary periods, the FIFO method can lead to an overstatement of reported profit.23 Because it matches older, lower inventory costs against current, higher sales revenues, the resulting profit may not accurately reflect the actual cost of replacing the goods sold. This can create "inventory profits" or "phantom profits" that do not represent true economic gains, potentially leading to higher income taxes and a misleading perception of a company's sustainable earnings.21, 22
Another limitation stems from situations where the physical flow of goods does not actually follow FIFO, such as in certain industries dealing with non-perishable bulk goods (e.g., coal piles, sand, or gravel) where the newest items might be removed first. While accounting methods do not always need to perfectly match the physical flow, a significant divergence can reduce the method's representational faithfulness.
Moreover, while FIFO results in an ending inventory balance that closely reflects current replacement costs on the balance sheet, its impact on the income statement can make period-over-period comparisons challenging during volatile economic times. Supply chain disruptions, for instance, can cause unpredictable shifts in input costs, complicating the analysis of a company's true operating performance under FIFO.19, 20 Businesses facing such challenges must carefully manage their inventory strategies and consider the implications of their chosen accounting methods.17, 18
FIFO Method 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 for inventory valuation. The fundamental difference lies in which inventory costs are expensed first.
The FIFO method assumes that the oldest units purchased are the first ones sold. This means that the Cost of Goods Sold (COGS) reflects the cost of the earliest inventory, while the ending inventory on the balance sheet is valued at the cost of the most recently acquired units.15, 16 This often aligns with the natural physical flow of goods, particularly for perishable items or those with short shelf lives.
In contrast, the LIFO method assumes that the most recently purchased units are the first ones sold. Consequently, COGS reflects the cost of the newest inventory, and the ending inventory is valued at the cost of the oldest units.14 LIFO is permitted under U.S. GAAP but is prohibited under IFRS due to concerns about it not accurately representing the physical flow of goods and potentially leading to less transparent financial reporting.13
During periods of inflation, FIFO typically results in a lower COGS and a higher reported net income, as it expenses cheaper, older inventory. This leads to a higher ending inventory value.11, 12 Conversely, LIFO results in a higher COGS and lower reported net income, as it expenses more expensive, newer inventory, leading to a lower ending inventory value.9, 10 The choice between FIFO and LIFO significantly impacts a company's financial statements and tax liabilities, particularly in changing economic conditions.8
FAQs
What types of businesses typically use the FIFO method?
Businesses that deal with perishable goods (like food and pharmaceuticals), fashion items, or electronics often use the FIFO method because it aligns with their need to sell older products first to prevent obsolescence or spoilage.6, 7 It also applies to companies where older inventory should physically move out before newer inventory.
How does the FIFO method affect taxes?
During periods of rising prices (inflation), the FIFO method generally results in a lower Cost of Goods Sold and a higher reported gross profit. This can lead to a higher taxable income and, consequently, a greater tax liability for the company compared to the LIFO method.5
Is the FIFO method allowed internationally?
Yes, the FIFO method is widely accepted globally. It is permitted under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS), which are used in many other countries.3, 4 This makes FIFO a common choice for multinational companies seeking consistent accounting practices.
Can a company switch from FIFO to another method?
Switching inventory accounting methods typically requires justification to the relevant accounting bodies and tax authorities (like the IRS). A company usually needs to demonstrate that the new method is preferable and provides a more accurate representation of its financial position. Once a method is chosen, consistency is generally required.2
Does the FIFO method always reflect the physical flow of goods?
While the FIFO method often aligns with the physical flow of goods, especially for perishable items, it's important to remember that it is a cost flow assumption. This means that the accounting treatment assumes the oldest costs are expensed first, regardless of whether the physical items literally left the warehouse in that exact order. For many businesses, however, the accounting assumption closely mirrors their operational practice.1