First in first out

What Is First in first out?

First in first out (FIFO) is an inventory accounting method that assumes the first items purchased or produced by a business are the first ones sold, consumed, or otherwise disposed of. This method is a key component of inventory accounting, which falls under the broader financial category of corporate finance and financial reporting. When a company uses the First in first out method, it assumes that the oldest goods in its inventory are expensed as cost of goods sold, while the newer, more recently acquired items remain in closing inventory. This approach is widely used globally and is permitted under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS).

History and Origin

The concept behind the First in first out method aligns with the natural flow of many businesses, particularly those dealing with perishable goods or products with limited shelf lives. While the general practice of tracking goods has existed for millennia, from ancient tally sticks to modern digital systems, the formalization of inventory costing methods like First in first out emerged with the development of modern accounting principles.⁷,⁶

Accounting standards bodies have since codified First in first out as an acceptable method for valuing inventory. For instance, the International Accounting Standards Board (IASB) provides guidance on inventory valuation, including the First in first out method, under IAS 2, Inventories. IAS 2 specifies that the cost of inventories should be assigned using either the First in first out or weighted average cost method.⁵,⁴ Similarly, the Financial Accounting Standards Board (FASB) in the U.S., through its Accounting Standards Codification (ASC) Topic 330, Inventory, recognizes First in first out as a permissible method. In 2015, the FASB issued Accounting Standards Update (ASU) 2015-11, simplifying the measurement of inventory for entities using First in first out or average cost methods, requiring them to measure inventory at the lower of cost and net realizable value.³

Key Takeaways

• First in first out (FIFO) is an inventory costing method assuming the oldest inventory items are sold first.
• It generally results in higher reported profits during periods of rising costs, as lower-cost inventory is expensed first.
• The ending inventory balance under First in first out reflects more recent costs, providing a more up-to-date value on the balance sheet.
• First in first out is permitted under both GAAP and IFRS, making it a globally accepted accounting method.
• It typically aligns with the physical flow of goods for many businesses, especially those with perishable or time-sensitive products.

Formula and Calculation

The First in first out method calculates the cost of goods sold by taking the cost of the earliest acquired units, and determines the value of ending inventory by pricing the remaining units at the cost of the latest acquisitions.

To calculate the cost of goods sold (COGS) using First in first out:

To calculate ending inventory (EI) using First in first out:

Where:

• Units Sold from Oldest Inventory: The quantity of goods sold, assumed to be from the earliest purchases.
• Cost per Unit of Oldest Inventory: The per-unit cost of the earliest purchased goods.
• Units Remaining in Inventory: The quantity of goods not yet sold at the end of the period.
• Cost per Unit of Newest Inventory: The per-unit cost of the most recently purchased goods, which are assumed to be still on hand.

Interpreting the First in first out

Interpreting the First in first out method involves understanding its impact on a company's financial statements, particularly the income statement and balance sheet. When a company uses First in first out, the cost of goods sold reflects the cost of older inventory. During periods of inflation, where costs are generally rising, this means that lower, older costs are matched against current revenues, resulting in a lower cost of goods sold and consequently higher gross profit and taxable income. Conversely, during periods of deflation, First in first out would result in a higher cost of goods sold and lower reported profits.

The ending inventory reported on the balance sheet under First in first out represents the cost of the most recently purchased items. This typically means that the inventory value on the balance sheet is closer to current market values, especially during inflationary periods, as it reflects the latest acquisition costs. This can provide a more accurate representation of the value of a company's current assets.

Hypothetical Example

Consider a small electronics retailer, "TechGadgets," that sells a popular smart home device.

• January 1: Beginning inventory of 10 units at $50 each.
• January 10: Purchases 20 units at $55 each.
• January 20: Purchases 15 units at $60 each.
• January 25: Sells 30 units during the month.

To calculate the cost of goods sold using First in first out:

1. The first 10 units sold are from the beginning inventory (oldest): 10 units × $50 = $500.
2. The next 20 units sold are from the January 10 purchases: 20 units × $55 = $1,100.
   Total units sold = 10 + 20 = 30 units.
   Total COGS = $500 + $1,100 = $1,600.

To calculate the ending inventory:

• Original inventory: 10 + 20 + 15 = 45 units.
• Units sold: 30 units.
• Units remaining: 45 - 30 = 15 units.
  These 15 remaining units are assumed to be from the most recent purchases.
• The 15 units are from the January 20 purchase: 15 units × $60 = $900.
  Ending inventory = $900.

Practical Applications

First in first out is widely applied across various industries, particularly where the physical flow of goods naturally follows this assumption. For instance, grocery stores, food service businesses, and pharmaceutical companies often use First in first out because their products are perishable or have expiration dates, necessitating that older items are sold before newer ones to minimize spoilage and waste.

Beyond physical inventory, the First in first out principle is also relevant in financial markets for calculating capital gains and losses on investment securities. When an investor sells shares of stock acquired at different times and prices, the Internal Revenue Service (IRS) generally assumes a First in first out cost basis unless the investor specifies otherwise. This means the shares bought first are assumed to be sold first for tax purposes, impacting the reported taxable income. Br²okerage platforms often default to First in first out for transactions, aligning with regulatory standards from bodies like the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to ensure consistent financial reporting. Th¹is method influences a company's reported profitability and the valuation of its current assets on its financial statements.

Limitations and Criticisms

While First in first out is a logical and widely accepted inventory costing method, it does have limitations, particularly concerning its impact on financial reporting during periods of significant price fluctuations. A primary criticism arises during times of high inflation. In such an environment, the First in first out method matches older, lower inventory costs against current, higher sales revenues. This can lead to a lower reported cost of goods sold and, consequently, higher gross profit and taxable income than if more recent costs were used. While this might appear beneficial, it can result in a company paying higher taxes in the present, even if it needs to replace inventory at much higher current costs. This can also distort the true economic performance by overstating current period earnings relative to the actual cost of replacing the goods sold.

Another limitation is that while First in first out often mirrors the physical flow of goods, it doesn't always align perfectly with the actual cost flow, especially for businesses that might store inventory in ways that don't strictly adhere to "first in, first out" movement, or for items that are not easily interchangeable and are tracked by specific identification. The method's reliance on historical costs for the income statement can sometimes obscure the true economic impact of rising input prices on a business's operational efficiency.

First in first out vs. Last in first out

First in first out (FIFO) and Last in first out (LIFO) are two prominent inventory costing methods, differing fundamentally in their assumptions about which inventory units are sold first. FIFO assumes that the oldest units of inventory are sold first, meaning the cost of goods sold reflects these older costs, and ending inventory is valued at the cost of the most recent purchases. In contrast, Last in first out (LIFO) assumes that the newest inventory items are sold first, so the cost of goods sold reflects the most recent costs, while ending inventory consists of the older, lower-cost items.

The primary confusion between the two methods arises from their impact on a company's financial statements, particularly during periods of inflation or deflation. During inflation, FIFO results in a lower cost of goods sold and higher reported profit, leading to a higher taxable income. LIFO, on the other hand, reports a higher cost of goods sold (matching current costs with current revenues) and lower profit, potentially leading to lower tax liabilities. However, LIFO is only permitted under U.S. Generally Accepted Accounting Principles (GAAP) and is not allowed under International Financial Reporting Standards (IFRS), making FIFO the more common method globally.

FAQs

What types of businesses commonly use First in first out?

Businesses that deal with perishable goods, products with expiry dates, or items that naturally move in a chronological order often use First in first out. Examples include grocery stores, bakeries, food manufacturers, and pharmacies.

How does First in first out affect a company's taxes?

In an inflationary environment, First in first out generally results in a lower cost of goods sold and thus a higher reported gross profit and taxable income. This can lead to a higher tax liability compared to other inventory costing methods like Last in first out.

Is First in first out allowed under all accounting standards?

Yes, First in first out is widely accepted globally. It is permitted under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS), making it a common choice for businesses worldwide.

Does First in first out always reflect the actual physical flow of goods?

While First in first out often aligns with the physical flow of goods for many businesses, especially those with perishable inventory, it is an accounting assumption and does not always precisely match the physical movement of every single item. It is a cost flow assumption, not necessarily a physical flow requirement.