First in, first out fifo

What Is First In, First Out (FIFO)?

First In, First Out (FIFO) is an inventory valuation method and accounting approach that assumes the first goods purchased or produced are the first ones sold, consumed, or disposed of. This principle, foundational in inventory management, dictates that the oldest inventory items are expensed as cost of goods sold (COGS) when a sale occurs, while the newest items remain in the company's inventory on the balance sheet. FIFO is widely used across various industries, from retail to manufacturing, as it generally reflects the physical flow of goods for perishable items or those with limited shelf lives. It falls under the broader financial category of accounting methods.

History and Origin

The concept of matching costs to revenues, which underpins inventory valuation methods like First In, First Out (FIFO), has evolved alongside modern accounting principles. As businesses grew in complexity and the need for standardized financial reporting became apparent, methods for tracking and valuing inventory became crucial. The explicit formalization of inventory costing methods, including FIFO, developed as part of the broader framework of accounting standards in the 20th century. These standards provide guidelines for how businesses record and report their financial activities, ensuring consistency and comparability in financial statements. For instance, the Internal Revenue Service (IRS) in the United States outlines various permissible accounting periods and methods, including those for inventory, in publications such as IRS Publication 538.⁵, ⁶ Businesses must consistently apply their chosen accounting method, and any changes typically require approval from the IRS.⁴

Key Takeaways

• Cost Flow Assumption: FIFO assumes that the earliest purchased inventory items are the first ones sold, aligning with the physical flow for many businesses.
• Impact on Financial Statements: In an environment of rising costs (inflation), FIFO results in a lower cost of goods sold, higher reported gross profit, and a higher ending inventory value.
• Real-World Relevance: FIFO often mirrors the actual movement of goods, especially for perishable products or those with expiration dates.
• Global Acceptance: It is a widely accepted inventory valuation method under both Generally Accepted Accounting Principles (GAAP)) and International Financial Reporting Standards (IFRS)).
• Simplicity and Clarity: FIFO is generally considered straightforward to understand and apply, making financial reporting more transparent.

Formula and Calculation

First In, First Out (FIFO) is a cost flow assumption rather than a strict mathematical formula in the traditional sense, but its application directly affects the calculation of cost of goods sold (COGS) and ending inventory. The "formula" involves identifying which specific costs are assigned to units sold and which remain in inventory.

To calculate COGS and ending inventory under FIFO, one must track the costs of purchases over time. This can be done using either a perpetual inventory system or a periodic inventory system.

• Cost of Goods Sold (COGS) under FIFO: $$\text{COGS} = \text{Cost of oldest inventory units sold}$$
• Ending Inventory under FIFO: $$\text{Ending Inventory} = \text{Cost of newest inventory units remaining}$$

In practice, this means when a sale occurs, the cost associated with the very first units acquired is removed from inventory and recognized as an expense. The value of the remaining inventory on the balance sheet reflects the costs of the most recently purchased items.

Interpreting the First In, First Out (FIFO)

Interpreting the financial statements of a company using First In, First Out (FIFO) requires understanding its implications, particularly in periods of changing prices. When prices for inventory are rising (inflation), FIFO will result in a lower cost of goods sold because it matches older, lower costs against current revenues. This leads to a higher reported gross profit and, consequently, higher net income. The ending inventory balance on the balance sheet will also be higher, as it consists of the most recently purchased, higher-cost items.

Conversely, in periods of falling prices (deflation), FIFO would show a higher cost of goods sold, lower gross profit, and lower net income, while ending inventory would reflect older, higher costs. This characteristic of FIFO means that the reported financial figures for profitability and asset value tend to be closer to current market values for inventory when prices are rising, which can be beneficial for financial reporting.

Hypothetical Example

Consider a small electronics retailer, "TechMart," that sells a popular model of wireless earbuds. TechMart uses the First In, First Out (FIFO) inventory valuation method.

TechMart's Earbud Purchases:

• January 5: Purchased 100 units at $50 each
• January 15: Purchased 150 units at $55 each
• January 25: Purchased 200 units at $60 each

Total units available for sale = 450 units.

TechMart's Earbud Sales in January:

• January 30: Sold 300 units

Now, let's calculate the cost of goods sold (COGS) and ending inventory using FIFO:

Step 1: Calculate Cost of Goods Sold (COGS)
Under FIFO, the first units purchased are the first ones sold. TechMart sold 300 units.

• From January 5 purchase: 100 units @ $50 = $5,000 (These are the "first in" units)
• From January 15 purchase: 150 units @ $55 = $8,250 (These are the next oldest units)
• Remaining units needed (300 total sold - 100 from Jan 5 - 150 from Jan 15 = 50 units) from January 25 purchase: 50 units @ $60 = $3,000

Total COGS = $5,000 + $8,250 + $3,000 = $16,250

Step 2: Calculate Ending Inventory
The remaining units in inventory are from the most recent purchases.

• From January 25 purchase: 200 units (original) - 50 units (sold) = 150 units remaining @ $60 = $9,000

So, TechMart's ending inventory at the end of January for this earbud model is $9,000.

This example illustrates how FIFO consistently matches the oldest costs with sales, leaving the most recent costs in the inventory balance.

Practical Applications

First In, First Out (FIFO) is widely applied across various aspects of business and finance, particularly in inventory valuation and financial reporting. Its practical applications include:

• Retail and Perishable Goods: Many retail businesses, especially those dealing with food, pharmaceuticals, or other items with expiration dates, naturally follow a FIFO physical flow. Selling older stock first minimizes spoilage and obsolescence.
• Manufacturing: Manufacturers often use FIFO for raw materials, work-in-process, and finished goods inventory. This ensures that older components are used first, optimizing storage and reducing waste.
• Financial Statement Presentation: Companies choose FIFO because it typically presents a more accurate representation of current inventory values on the balance sheet in an inflationary environment, as the remaining inventory is valued at recent costs.
• Compliance with Accounting Standards: FIFO is permitted under both Generally Accepted Accounting Principles (GAAP)) in the United States and International Financial Reporting Standards (IFRS)) globally. In fact, IFRS explicitly prohibits the use of the Last In, First Out (LIFO)) method, making FIFO a common choice for multinational corporations seeking to align their accounting practices.³
• Consistency in Reporting: Once adopted, a company must consistently apply FIFO or obtain permission from relevant authorities, such as the IRS, to change its accounting method.² This consistency is vital for allowing stakeholders to compare financial performance over different periods.

Limitations and Criticisms

While First In, First Out (FIFO) is a widely accepted and intuitive inventory valuation method, it also has certain limitations and faces criticisms, particularly concerning its impact on reported profitability during periods of significant price changes.

One primary criticism arises during periods of inflation, where the cost of acquiring new inventory is consistently rising. Under FIFO, the cost of goods sold (COGS) is calculated using the older, lower costs. This results in a higher reported gross profit and net income, which can make a company appear more profitable than it might be if it were matching current costs against current revenues. This can lead to higher taxable income and, consequently, higher income tax liabilities. For example, sustained inflation can impact various business costs, including wages, which indirectly affects the overall cost structure and thus the perception of profitability under FIFO.¹

Another limitation is that while FIFO often reflects the actual physical flow of goods, particularly for perishable items, it may not accurately reflect the true economic matching of current revenues with current costs for businesses where inventory turns over rapidly and replacement costs are immediately relevant. In such cases, some argue that the financial statements might not fully capture the economic reality of the business. Additionally, during periods of rapid technological change or fashion trends, older inventory valued under FIFO might become obsolete, potentially overstating the asset value on the balance sheet if not properly adjusted.

First In, First Out (FIFO) vs. Last In, First Out (LIFO)

First In, First Out (FIFO) and Last In, First Out (LIFO)) are two fundamental inventory valuation methods, differing primarily in their assumptions about which inventory costs are expensed first. This distinction has a significant impact on a company's reported cost of goods sold (COGS), ending inventory value, and ultimately, its profitability and tax obligations.

Confusion often arises because, while FIFO typically reflects the actual movement of physical goods for many companies, LIFO is a purely accounting convention that assumes a cost flow. Companies choosing between the two often consider their industry, the nature of their inventory, and the prevailing economic environment (e.g., inflation or deflation) due to the different impacts on reported profits and tax implications.

FAQs

What type of businesses typically use FIFO?

Businesses that deal with perishable goods (like food products, flowers), fashion items, or products with limited shelf lives frequently use First In, First Out (FIFO). This is because selling older inventory first helps to minimize spoilage, obsolescence, and waste. Additionally, many companies, especially multinational ones, opt for FIFO to align with International Financial Reporting Standards (IFRS)), which do not permit the Last In, First Out (LIFO)) method.

How does FIFO affect a company's taxes?

In a period of rising prices (inflation), First In, First Out (FIFO) results in a lower cost of goods sold and a higher reported gross profit. This higher profit generally leads to a higher taxable income and, consequently, higher income tax payments compared to methods like LIFO in the same inflationary environment.

Does FIFO always reflect the actual physical flow of goods?

First In, First Out (FIFO) often reflects the actual physical flow of goods for many businesses, particularly those managing perishable or time-sensitive inventory. However, it is fundamentally a cost flow assumption for inventory valuation. Even if a company's physical inventory movement doesn't perfectly match FIFO, the method can still be applied for accounting purposes as long as it's consistently maintained.

What happens to the balance sheet under FIFO?

Under First In, First Out (FIFO), the balance sheet reports inventory values that generally reflect the most recent costs. In an inflationary environment, this means the ending inventory figure on the balance sheet will be higher and more closely aligned with current market prices for the inventory assets. This contrasts with methods like LIFO, which would report older, potentially lower, inventory costs.