What Is First-In, First-Out (FIFO)?
First-In, First-Out (FIFO) is an inventory valuation method that assumes the first goods purchased or produced by a company are the first ones sold, consumed, or otherwise disposed of. This method is widely used within inventory accounting as a way to assign costs to goods sold and to remaining inventory. FIFO aligns with the natural physical flow of most businesses, where older products are typically sold before newer ones to prevent obsolescence or spoilage. Companies use FIFO to determine the cost of goods sold (COGS) and the value of their ending inventory on their financial statements.
History and Origin
The need for structured accounting methods like FIFO arose with the growth of commerce and the increasing complexity of businesses requiring accurate financial reporting. While the precise origin of the FIFO method is not tied to a single invention date, its formal recognition and codification began in the 20th century as accounting standards evolved. In the United States, the Financial Accounting Standards Board (FASB), established in 1973, plays a key role in setting Generally Accepted Accounting Principles (GAAP), which include guidelines for inventory valuation methods. Globally, the International Accounting Standards Board (IASB) governs International Financial Reporting Standards (IFRS), which also prescribe rules for inventory, including the use of FIFO. International Accounting Standard (IAS) 2, titled "Inventories," specifically addresses how to account for most types of inventory and permits the use of FIFO.4
Key Takeaways
- FIFO assumes that the oldest inventory items are sold first.
- This method generally results in a higher gross profit and taxable income during periods of rising costs.
- It often matches the physical flow of goods, particularly for perishable or time-sensitive products.
- FIFO is permitted under both GAAP and IFRS for inventory valuation.
- The use of FIFO impacts a company's reported COGS and ending inventory value on its balance sheet.
Formula and Calculation
The FIFO method does not use a single overarching formula like some financial ratios. Instead, it is a cost flow assumption applied to calculate the cost of goods sold and the value of ending inventory. The calculation involves identifying the cost of the earliest purchased units to be matched with sales and the cost of the latest purchased units remaining in inventory.
To calculate COGS using FIFO:
To calculate Ending Inventory using FIFO:
For example, if a company has multiple purchases of an inventory item at different costs, when a sale occurs, FIFO dictates that the cost assigned to that sale will be from the first units acquired. The remaining inventory will then consist of the most recently acquired units. This requires careful tracking, often facilitated by a perpetual inventory system.
Interpreting the FIFO Method
Interpreting the FIFO method involves understanding its implications for a company's financial statements, particularly the income statement and balance sheet. Because FIFO assumes the oldest costs are expensed first, in an environment of rising prices (inflation), this method results in a lower reported cost of goods sold (COGS). A lower COGS leads to a higher reported gross profit and, consequently, higher net income and taxable income. Conversely, during periods of falling prices, FIFO would yield a higher COGS and lower reported profit. The ending inventory value under FIFO typically reflects more recent costs, which closely approximates current market value on the balance sheet. This can provide a more accurate representation of the asset's current value.
Hypothetical Example
Consider a small electronics retailer, TechGadgets Inc., that sells a popular smart home device.
Here are TechGadgets' purchases of the device during July:
- July 5: 100 units at $50 each
- July 15: 150 units at $55 each
- July 25: 200 units at $60 each
Total units available for sale: (100 + 150 + 200 = 450) units.
On July 30, TechGadgets sells 300 units of the smart home device. Using the First-In, First-Out (FIFO) method, the cost of goods sold (COGS) is calculated as follows:
- First 100 units sold: From the July 5 purchase at $50 each.
(100 \text{ units} \times $50/\text{unit} = $5,000) - Next 150 units sold: From the July 15 purchase at $55 each.
(150 \text{ units} \times $55/\text{unit} = $8,250) - Remaining 50 units sold (to reach 300 total): From the July 25 purchase at $60 each.
(50 \text{ units} \times $60/\text{unit} = $3,000)
Total COGS = ($5,000 + $8,250 + $3,000 = $16,250)
Now, let's determine the ending inventory value. TechGadgets started with 450 units and sold 300, leaving 150 units in ending inventory. Under FIFO, these 150 units are assumed to be the last ones purchased:
- Remaining from July 25 purchase: (200 - 50 = 150) units at $60 each.
- Ending Inventory Value = (150 \text{ units} \times $60/\text{unit} = $9,000)
This example demonstrates how FIFO prioritizes the oldest costs for expensing, leaving the newest costs in ending inventory.
Practical Applications
The First-In, First-Out (FIFO) method is widely applied across various industries for valuing inventory and calculating the cost of goods sold. Its practical application often aligns with the actual physical flow of goods, especially for businesses dealing with perishable items or those subject to rapid technological obsolescence.
- Food and Beverage Industry: Restaurants and grocery stores typically use FIFO because older produce, dairy, and meat must be sold first to minimize spoilage and waste.
- Fashion and Retail: Clothing stores often prioritize selling older collections to make way for new seasons, naturally following a FIFO flow.
- Electronics and Technology: With rapid advancements, older electronic models quickly lose value, making FIFO a suitable method to expense the costs of items that are likely to become obsolete first.
- Manufacturing: Companies producing components or products with a shelf life apply FIFO to ensure older materials are used in production before newer ones.
For taxation purposes, the Internal Revenue Service (IRS) in the United States outlines acceptable accounting methods, including FIFO, in publications like IRS Publication 538.3,2 Companies must consistently apply their chosen inventory method from year to year to ensure clarity in financial reporting.
Limitations and Criticisms
While First-In, First-Out (FIFO) is widely accepted and often mirrors the physical flow of goods, it has certain limitations and criticisms, particularly concerning its impact on financial statements during periods of significant price changes.
One major criticism arises during periods of high inflation. Because FIFO assumes the oldest, typically lower, costs are expensed first, it results in a lower cost of goods sold (COGS) and, consequently, a higher reported gross profit and net income. While this might appear beneficial, it can lead to a higher taxable income, resulting in a greater tax burden for the company. This phenomenon was particularly noticeable during inflationary periods, such as the 1970s, where the choice between inventory methods like FIFO and LIFO could significantly alter reported profit levels.1
Another limitation is that during deflationary periods (falling prices), FIFO would result in a higher COGS and lower reported net income, which could make a company appear less profitable than it truly is based on current market conditions. While the ending inventory on the [balance sheet](https://diversification.com/term/balance sheet) under FIFO typically reflects current costs, the COGS on the income statement may not reflect the current cost of replacing the goods sold. This can create a mismatch between current revenues and older costs, potentially distorting a company's operational profitability in a fluctuating price environment.
FIFO vs. LIFO
First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) are two common inventory accounting methods that differ fundamentally in their assumptions about the flow of costs. FIFO assumes that the first units purchased are the first ones sold. This method typically aligns with the physical flow of goods for most businesses, especially those dealing with perishable or time-sensitive products, and results in ending inventory values that reflect more recent costs.
In contrast, LIFO assumes that the last units purchased are the first ones sold. This means that the most recent costs are expensed as cost of goods sold, while the older costs remain in ending inventory.
The choice between FIFO and LIFO can have a significant impact on a company's reported gross profit, net income, and taxable income, particularly during periods of inflation or deflation. In an inflationary environment, FIFO generally leads to a lower COGS and higher reported profits, whereas LIFO results in a higher COGS and lower reported profits (and thus lower taxes). Conversely, during deflation, FIFO would report lower profits than LIFO. Notably, while FIFO is permitted globally under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), LIFO is generally only allowed under GAAP in the United States and is prohibited under IFRS. Another commonly used method, the weighted-average cost (WAC) method, calculates an average cost for all available units and applies it to both COGS and ending inventory, providing a middle ground between FIFO and LIFO.
FAQs
Why do companies use the FIFO method?
Companies often choose the FIFO method because it generally reflects the actual physical flow of goods, especially for products that are perishable or have a limited shelf life, like food or pharmaceuticals. It also results in an ending inventory value on the balance sheet that more closely approximates current market costs.
How does FIFO affect a company's taxes?
During periods of rising costs or inflation, FIFO typically results in a lower cost of goods sold (COGS) and a higher reported gross profit and net income. This higher reported income can lead to a higher taxable income and, consequently, a greater tax liability for the company compared to methods like LIFO.
Is FIFO allowed under IFRS?
Yes, the FIFO method is explicitly allowed under International Financial Reporting Standards (IFRS) for valuing inventory. IAS 2 "Inventories" permits both the FIFO method and the weighted-average cost method. However, IFRS prohibits the use of the LIFO method.