How to Calculate Cost of Goods Sold Using FIFO
Understand the FIFO inventory costing method to accurately calculate Cost of Goods Sold (COGS) and gain vital financial clarity.
Accurately determining the cost of goods sold (COGS) is fundamental for businesses dealing with physical products. Various methods exist to calculate COGS, and the choice of method can significantly impact a company’s financial statements and profitability. This foundational accounting concept helps businesses understand the true cost associated with their sales.
What is FIFO
The First-In, First-Out (FIFO) method is an inventory costing approach that assumes the first inventory units purchased are the first ones sold. This principle aligns with the natural flow of inventory for many businesses, especially those dealing with perishable goods or products that quickly become obsolete. By selling older stock first, companies can minimize spoilage and keep their inventory fresh.
When items are sold, their cost is assigned based on the earliest acquired inventory. This means older costs are recognized as expenses on the income statement before newer, potentially higher, costs. The remaining inventory on the balance sheet then reflects the costs of the most recently acquired items.
Understanding Cost of Goods Sold
Cost of Goods Sold (COGS) represents the direct costs incurred in producing the goods a company sells. These direct costs typically include the cost of raw materials, direct labor, and manufacturing overhead. Expenses not directly related to production, such as marketing or administrative salaries, are not included in COGS.
COGS is a component of a company’s income statement, appearing directly after sales revenue. It is subtracted from revenue to determine the gross profit, which indicates how much profit a company makes before accounting for operating expenses.
Steps to Calculate Cost of Goods Sold Using FIFO
Calculating Cost of Goods Sold using the FIFO method involves a systematic approach to assign costs to the units sold. The process begins by identifying the cost of the oldest inventory available. These costs are then matched against the units sold until all units in a particular cost layer are accounted for.
The first step is to determine the beginning inventory and its associated cost. Then, list all purchases made during the period in chronological order, noting the quantity and cost of each purchase. Maintaining this chronological record is essential for applying the FIFO principle accurately.
Next, identify the total number of units sold. This quantity will dictate how many units’ costs need to be pulled from the inventory layers. The FIFO calculation assumes units sold came from the earliest available inventory. You assign costs from the beginning inventory first, then from the first purchase, then the second, and so on, until the total units sold are reached.
For example, consider a small electronics retailer. On January 1, the retailer had a beginning inventory of 50 units of a specific headphone model, each costing $20. During January, the retailer made two purchases: on January 10, 100 units were bought at $22 each, and on January 20, another 75 units were purchased at $25 each. By the end of January, the retailer sold a total of 180 units.
To calculate COGS using FIFO, the 180 units sold are assumed to come from the oldest stock first. The first 50 units sold would be from the beginning inventory, costing $20 each, totaling $1,000. The next 100 units sold would come from the January 10 purchase, costing $22 each, totaling $2,200. The remaining 30 units sold (180 total units sold – 50 from beginning inventory – 100 from first purchase) would be sourced from the January 20 purchase, costing $25 each, totaling $750. Summing these amounts yields the total COGS: $1,000 + $2,200 + $750, which equals $3,950.
Inventory Records for FIFO
Effective inventory record-keeping is necessary to accurately apply the FIFO method. Businesses typically use one of two main inventory systems: periodic or perpetual. Both systems can accommodate FIFO, but they differ in how frequently inventory balances and COGS are updated.
Under a periodic inventory system, businesses do not continuously track inventory levels. A physical count of inventory is performed at the end of an accounting period to determine the ending inventory balance. With this system, the FIFO calculation for COGS is performed retrospectively at the end of the period, using the chronological records of purchases and the final inventory count.
In contrast, a perpetual inventory system maintains continuous, real-time records of inventory. Each time an item is purchased or sold, the inventory records are immediately updated. When using FIFO with a perpetual system, the cost of goods sold is calculated and recorded at the time of each sale, ensuring that the inventory cost flow aligns with the FIFO assumption instantly.