First in,20first out20fifo: Meaning, Criticisms & Real-World Uses

What Is First In, First Out (FIFO)?

First In, First Out (FIFO) is an inventory valuation method that assumes the first units of inventory purchased or produced are the first ones sold. This accounting principle directly impacts a company's financial statements, specifically the balance sheet and income statement, by determining the cost of goods sold (COGS) and the value of remaining inventory. FIFO is widely used across various industries because it aligns with the natural flow of most businesses, where older stock is typically sold before newer stock to prevent obsolescence or spoilage. It's a fundamental concept in accrual accounting for businesses that maintain tangible goods.

History and Origin

The need for consistent accounting methods for inventory has long been recognized to accurately reflect a company's financial position. As businesses grew and inventory management became more complex, different methods for costing goods were developed. FIFO emerged as a logical and intuitive approach, mirroring the physical flow of goods for many companies. Its formalization and inclusion in accounting standards underscore its importance. For instance, International Accounting Standard 2 (IAS 2) on Inventories, adopted by the International Accounting Standards Board (IASB) in April 2001, explicitly provides guidance on the cost formulas used to assign costs to inventories, including the First In, First Out (FIFO) method.⁶ This standard emphasizes that the cost of inventories includes all costs incurred in bringing the inventories to their present location and condition.⁵

Key Takeaways

FIFO assumes that the oldest inventory items are sold first, regardless of their actual physical movement.
This method generally results in a higher net income and ending inventory value during periods of inflation.
During periods of deflation, FIFO typically leads to a lower net income and ending inventory value.
It is favored because it often aligns with the physical flow of goods and presents a more realistic picture of current inventory values on the balance sheet.
FIFO is a permissible inventory costing method under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally.

Calculating First In, First Out (FIFO)

The First In, First Out (FIFO) method assigns costs to sold goods based on the assumption that the earliest acquired inventory units are the first ones dispatched from stock. To calculate COGS and ending inventory under FIFO, a business identifies the cost of the first units purchased. When a sale occurs, these oldest costs are expensed as COGS. The remaining inventory is then valued using the costs of the most recently acquired units.

Consider a simple example:

Beginning Inventory: 10 units at $10 each
Purchase 1: 20 units at $12 each
Purchase 2: 15 units at $13 each

If 25 units are sold:

The first 10 units sold are from the beginning inventory: (10 \text{ units} \times $10/\text{unit} = $100)
The next 15 units sold are from Purchase 1: (15 \text{ units} \times $12/\text{unit} = $180)

Total COGS = ( $100 + $180 = $280 ).
Remaining inventory would consist of the remaining units from Purchase 1 ((20 - 15 = 5) units) and all units from Purchase 2. The cost basis for these assets would be based on their respective purchase prices.

Interpreting the First In, First Out (FIFO) Method

Interpreting the First In, First Out (FIFO) method involves understanding its implications for a company's financial health, particularly in varying economic conditions. When prices are rising due to inflation, FIFO assigns the lowest (oldest) costs to COGS, resulting in a higher reported gross profit and taxable income. Conversely, the ending inventory on the balance sheet is valued at the more recent, higher costs, which reflects the current replacement cost basis of assets more accurately.

In a deflationary environment, where prices are falling, FIFO will attribute higher (older) costs to COGS, leading to a lower gross profit and taxable income. The ending inventory will then be valued at lower, more recent costs. Therefore, the choice of inventory method, like FIFO, can significantly influence a company's reported profitability and the valuation of its assets.

Hypothetical Example

Consider "Gadget Co.," a retailer of electronic components.

January 5: Gadget Co. purchases 100 units of Component A at $5.00 per unit.
January 15: Gadget Co. purchases another 150 units of Component A at $5.50 per unit.
January 25: Gadget Co. sells 120 units of Component A.

To calculate the cost of goods sold (COGS) using FIFO:

The first 100 units sold are assumed to be from the January 5 purchase: (100 \text{ units} \times $5.00/\text{unit} = $500).
The remaining 20 units ((120 \text{ total sold} - 100 \text{ from first batch})) are assumed to be from the January 15 purchase: (20 \text{ units} \times $5.50/\text{unit} = $110).

Therefore, the total COGS for January 25 is $500 + $110 = $610.

The ending inventory would consist of the remaining units from the January 15 purchase: (150 \text{ units} - 20 \text{ units} = 130 \text{ units}) at $5.50 per unit. The value of the remaining inventory would be (130 \text{ units} \times $5.50/\text{unit} = $715). This approach directly affects the company's profitability and the reported value of its current assets.

Practical Applications

First In, First Out (FIFO) is widely applied across various business sectors due to its alignment with the physical flow of goods and its straightforward nature. In retail, grocery stores, and food service, FIFO is practical because perishable goods must be sold quickly to avoid spoilage. For example, a bakery selling bread naturally sells the loaves baked earlier in the day before later ones. Manufacturing firms also commonly use FIFO for their raw materials and finished goods, ensuring that older components are utilized first, which is critical in industries with evolving product designs or limited shelf life.

The method also plays a significant role in financial reporting and taxation. Companies must consistently apply their chosen accounting methods for tax purposes. According to IRS Publication 538, businesses that maintain inventory must generally use an accrual method for purchases and sales, and FIFO is one of the acceptable inventory costing methods.⁴ FIFO's impact extends to supply chain management, where effective inventory control is crucial. While supply chain disruptions can significantly impact inventory costs and availability, as seen in recent years,³ methods like FIFO help businesses track and manage the flow of goods and their associated expenses effectively.

Limitations and Criticisms

While First In, First Out (FIFO) is widely used, it has certain limitations, particularly concerning financial reporting during periods of significant price changes. During inflationary periods, FIFO results in a lower cost of goods sold (COGS) because it assigns the older, cheaper costs to the goods presumed sold. This leads to a higher reported gross profit and, consequently, higher taxable income. This can mean a larger tax liability for the business, even if its cash flow doesn't feel proportionally increased. Critics argue that this does not accurately reflect the current economic reality of replacing inventory at higher prices.

Conversely, during periods of deflation, FIFO assigns higher (older) costs to COGS, leading to a lower reported profit and potentially lower tax obligations. However, this also means the ending inventory values might be higher than their current replacement cost, overstating the asset value on the balance sheet. The U.S. Securities and Exchange Commission (SEC) oversees financial reporting by public companies and provides guidance on various accounting principles, including those related to inventory.² While not a direct criticism of FIFO itself, the SEC's emphasis on clear and consistent financial disclosures underscores the importance of choosing and applying an inventory method that accurately reflects a company's financial position and results.

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

The primary distinction between First In, First Out (FIFO) and Last In, First Out (LIFO) lies in their assumptions about the flow of inventory costs, which can significantly impact a company's financial statements. FIFO assumes that the first goods purchased or produced are the first ones sold. This generally aligns with the physical flow of goods for most businesses, especially those dealing with perishable items or products with short shelf lives. Under FIFO, the remaining inventory is valued at the most recent costs.

In contrast, LIFO assumes that the last goods purchased or produced are the first ones sold. This method is often chosen for tax benefits during periods of inflation in countries where it is permitted (such as the United States, although it is not allowed under IFRS). Under LIFO, the remaining inventory is valued at the oldest costs. During inflationary periods, LIFO results in a higher cost of goods sold (COGS) and lower taxable income compared to FIFO, as it matches the most expensive, recently acquired inventory with current revenues.

FAQs

Why do companies use First In, First Out (FIFO)?

Companies often use FIFO because it generally aligns with the actual physical flow of inventory, especially for perishable goods or products that become obsolete quickly. It also provides a more current valuation of inventory on the balance sheet.

How does First In, First Out (FIFO) affect profits during inflation?

During periods of inflation (rising prices), FIFO typically results in a higher reported profit (and thus higher taxable income). This is because it assumes the older, lower-cost inventory is sold first, leading to a lower cost of goods sold (COGS) and a higher net income.

Is First In, First Out (FIFO) allowed by IFRS?

Yes, the First In, First Out (FIFO) method is an allowable inventory costing method under International Financial Reporting Standards (IFRS).¹ IFRS generally does not permit the use of the Last In, First Out (LIFO) method.

What is the primary difference between First In, First Out (FIFO) and weighted-average cost?

FIFO assumes that inventory costs are used in the order they were incurred (first in, first out). The weighted-average cost method, another common inventory valuation method, calculates an average cost for all available inventory and applies that average cost to both the cost of goods sold and the ending inventory.