First in first out fifo

First in, First Out (FIFO): Definition, Formula, Example, and FAQs

First in, first out (FIFO) is an inventory valuation method within the broader field of financial accounting, which assumes that the first goods purchased or produced are the first ones sold. This method impacts a company's financial statements by influencing the calculation of the cost of goods sold (COGS) and the value of remaining inventory. FIFO is widely used across various industries to manage the flow of inventory and determine profitability.

History and Origin

The concept of valuing inventory based on the order of acquisition has ancient roots. The first recorded use of the first in, first out (FIFO) principle is thought to trace back to Italian merchants in the 14th century, who applied this method to account for the cost of their traded goods.¹⁰ Its prevalence expanded significantly in the 20th century with the development of modern accounting systems and the growth of manufacturing sectors. Today, FIFO remains one of the most common and accepted inventory accounting methods globally.⁹

Key Takeaways

• First in, first out (FIFO) assumes the oldest inventory items are sold first.
• This method generally leads to a higher inventory valuation on the balance sheet and a lower cost of goods sold during periods of inflation.
• FIFO is permitted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
• It is considered by many to be the most theoretically correct inventory valuation method as it often aligns with the natural physical flow of goods, particularly for perishable items.
• The application of FIFO affects key financial metrics, including gross margin and reported net income.

Formula and Calculation

The first in, first out (FIFO) method does not use a single formula in the traditional sense, but rather a cost flow assumption applied to calculate the cost of goods sold (COGS) and ending inventory. The core principle is to match the oldest costs with sales.

To determine the Cost of Goods Sold using FIFO:

To determine Ending Inventory using FIFO:

Where:

• Units Sold from Oldest Layer: Represents the quantity of goods sold, drawing from the earliest available inventory batches.
• Cost of Oldest Layer: The per-unit cost of the earliest inventory purchased or produced.
• Units Remaining from Newest Layer: The quantity of goods still on hand, which are assumed to be from the most recent purchases.
• Cost of Newest Layer: The per-unit cost of the most recent inventory purchased or produced.

This application means that the costs assigned to goods sold are from the earliest purchases, while the costs remaining in inventory are from the most recent purchases. Both the perpetual inventory system and the periodic inventory system can apply the FIFO method, yielding the same results.⁸

Interpreting the FIFO Method

Interpreting the first in, first out (FIFO) method primarily involves understanding its impact on a company's financial statements. Under FIFO, the ending inventory reported on the balance sheet reflects the most recent purchase prices, which typically aligns closely with current market values, especially in periods of stable or rising prices.⁷ This can present a more current representation of the asset's value.

Conversely, the cost of goods sold calculated under FIFO uses the oldest, often lower, costs. In an inflationary environment, where prices are rising, this results in a lower COGS and consequently, a higher gross margin and reported net income. Investors and analysts often consider this aspect when evaluating a company's profitability and comparing it to others that might use different inventory valuation methods. The method's ability to mirror the physical flow of goods for many businesses (e.g., perishable goods) makes it a straightforward and intuitive approach to inventory valuation.

Hypothetical Example

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

Inventory Purchases:

• January 1: 10 units at $100 each = $1,000
• January 15: 15 units at $110 each = $1,650
• January 25: 5 units at $120 each = $600

Total Available for Sale: 30 units, Total Cost = $3,250

Sales in February:

• TechGadgets sells 20 units during February.

Applying FIFO:
Under the first in, first out (FIFO) method, the first units sold are assumed to be from the earliest purchases.

1. From January 1 purchase: All 10 units at $100 each are considered sold first.
   • Cost: 10 units * $100 = $1,000
2. From January 15 purchase: The remaining 10 units needed for the sale (20 total sold - 10 from Jan 1 = 10 remaining) are taken from this batch.
   • Cost: 10 units * $110 = $1,100

Calculation:

• Cost of Goods Sold (COGS): $1,000 (from Jan 1) + $1,100 (from Jan 15) = $2,100

• Ending Inventory: The units remaining are from the latest purchases.

  • From January 15 purchase: 15 units – 10 units sold = 5 units remaining at $110 each.
  • Value: 5 units * $110 = $550
  • From January 25 purchase: All 5 units at $120 each remain.
  • Value: 5 units * $120 = $600
  • Total Ending Inventory: $550 + $600 = $1,150

Check: Beginning Inventory ($0) + Purchases ($3,250) = COGS ($2,100) + Ending Inventory ($1,150)
$3,250 = $3,250. The accounting equation balances.

Practical Applications

The first in, first out (FIFO) method has several practical applications across various aspects of business and finance:

• Inventory Management: For businesses dealing with perishable goods (like food products or pharmaceuticals) or items with limited shelf lives, FIFO physically aligns with the necessity to sell older stock first to minimize waste and obsolescence. W⁶hile the accounting method is a cost flow assumption, it often reflects the actual physical flow for these industries.
• Financial Reporting: Companies use FIFO to prepare their financial statements, including the income statement and balance sheet. It influences key metrics such as gross profit, net income, and the value of inventory assets reported. This information is crucial for investors, creditors, and other stakeholders to assess a company's financial health and performance.
• Taxation: The choice of inventory valuation method can have significant tax implications. In an inflationary environment, FIFO generally results in higher reported profits, which can lead to a higher tax liability compared to other methods that might report lower profits.
• Compliance: FIFO is an accepted inventory costing method under both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) used by many other countries worldwide. This broad acceptance facilitates its use by multinational corporations and for comparative financial analysis.
  *⁵ Loan Applications: A higher inventory valuation resulting from FIFO can positively impact a company's working capital and overall asset base, potentially making it more attractive to lenders when applying for loans.

⁴### Limitations and Criticisms

While widely used, the first in, first out (FIFO) method also has certain limitations and criticisms:

• Impact on Profitability in Inflationary Periods: A primary criticism of FIFO, particularly during periods of inflation, is that it can overstate a company's gross profit and net income. Because it matches the oldest, typically lower, costs with current revenues, the reported profit may not accurately reflect the actual economic performance in terms of replacing sold inventory at higher current costs. This can lead to a higher tax burden compared to other methods that might report lower profits.
• Misrepresentation of Current Costs: While FIFO's ending inventory value closely approximates current costs, the cost of goods sold does not. This means that the income statement may not accurately reflect the most current costs of doing business, potentially misrepresenting the true operating margin.
• Less Tax Benefit in Inflation: In countries where it is permitted, an alternative method like Last In, First Out (LIFO) can offer tax advantages during inflationary periods by reporting a higher COGS and thus lower taxable income. FIFO does not offer this same tax deferral benefit.
• Assumptions May Not Match Physical Flow: While often aligned with the physical flow for perishable goods, the FIFO cost assumption might not match the actual physical movement of inventory for all businesses. For instance, in industries where newer stock is deliberately sold first (e.g., certain building materials or bulk goods), the FIFO assumption might not reflect reality, though it is still an acceptable accounting practice.

FIFO vs. LIFO

The primary distinction between First In, First Out (FIFO) and Last In, First Out (LIFO) lies in their cost flow assumptions for inventory. Both are widely recognized inventory valuation methods, but they produce different results for the cost of goods sold and ending inventory, especially in environments with fluctuating prices.

Confusion between FIFO and LIFO often arises because while FIFO tends to match the physical flow of inventory for many businesses, the choice between these methods for accounting purposes is a cost assumption, not necessarily a reflection of the actual physical movement of goods. For example, a company might physically move older items first (FIFO), but choose to account for them using LIFO for tax benefits.

FAQs

What is the main purpose of the first in, first out (FIFO) method?
The main purpose of the first in, first out (FIFO) method is to assign a cost to the goods a company has sold and to the inventory remaining on hand. It helps businesses and accountants consistently value their inventory and calculate the cost of goods sold for financial reporting.

Does FIFO reflect the actual physical flow of goods?
For many businesses, especially those dealing with perishable items, food, or products with expiration dates, FIFO often closely mirrors the actual physical flow of inventory where older goods are indeed sold first to prevent spoilage or obsolescence. However, for other types of inventory, the physical flow might differ, but the FIFO cost assumption is still applied for accounting purposes.

How does FIFO affect a company's taxes?
In an environment where inventory costs are rising (inflation), the first in, first out (FIFO) method results in a lower cost of goods sold and, consequently, a higher reported gross profit and net income. A higher net income generally leads to a higher tax liability compared to methods like LIFO, which reports higher COGS and lower profit during inflation.

Is FIFO allowed under international accounting standards?
Yes, the first in, first out (FIFO) method is permitted and widely accepted under International Financial Reporting Standards (IFRS), which are used by many countries around the world. It is also accepted under Generally Accepted Accounting Principles (GAAP) in the United States.

¹Why might a company choose FIFO?
Companies might choose the first in, first out (FIFO) method because it often aligns with the natural physical flow of their inventory, particularly for perishable goods. It also results in an ending inventory value on the balance sheet that is close to current market prices, which can provide a more accurate representation of the asset's worth. Furthermore, FIFO is universally accepted by major accounting standards, simplifying international financial reporting.