How to Calculate Gross Profit Using FIFO

Calculating gross profit is fundamental for businesses to assess financial performance. This metric provides insight into how efficiently a company manages production costs relative to sales revenue. It helps businesses understand core operational profitability before other expenses. Inventory costing methods, like First-In, First-Out (FIFO), significantly influence gross profit. Understanding FIFO’s impact is essential for accurate financial reporting and informed decision-making.

Understanding Gross Profit Components

Gross profit is derived from two primary components: net sales and the cost of goods sold (COGS). Net sales represent total revenue generated from sales after accounting for deductions. These deductions typically include sales returns, sales allowances, and sales discounts. The resulting net sales figure provides a more accurate representation of the actual revenue a business receives from its sales activities.

The cost of goods sold includes all direct costs associated with producing or acquiring the goods that a company sells. This encompasses raw materials, direct labor, and manufacturing overhead directly tied to the production process. The basic formula for COGS is beginning inventory plus purchases made during the period, minus the ending inventory. COGS is a variable cost, meaning it fluctuates with the level of production output, and it does not include indirect costs like administrative expenses or marketing.

The First-In, First-Out (FIFO) Inventory Method

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced by a business are also the first ones to be sold. This means the oldest inventory costs are expensed first when a sale occurs.

This assumption directly impacts how inventory costs are assigned. When a sale is made, the cost associated with that sale is taken from the earliest available inventory. Consequently, the inventory remaining at the end of an accounting period consists of the most recently purchased or produced items. In periods of rising costs, FIFO results in a lower Cost of Goods Sold because the older, cheaper inventory is sold first, which generally leads to a higher reported gross profit and a higher valuation for ending inventory on the balance sheet.

Calculating Gross Profit Using FIFO

Calculating gross profit under the FIFO method integrates net sales with the FIFO-determined cost of goods sold. First, determine the net sales figure for the period. This involves starting with total gross sales and then subtracting any customer returns, allowances, or discounts. This adjusted sales figure accurately reflects the revenue earned from sales transactions.

Next, calculate the Cost of Goods Sold (COGS) using the FIFO principle. This is achieved by identifying the units sold and assigning costs based on the assumption that the oldest inventory items are sold first. This method ensures that the cost flow follows the first-in, first-out assumption, even if the physical flow of goods differs.

Finally, subtract the calculated COGS from the net sales figure. This calculation reveals the profit generated from a company’s core operations before considering operating expenses, interest, or taxes.

Illustrative Example

Consider a hypothetical business, “Gadget Co.,” that sells a single product. At the beginning of July, Gadget Co. had no inventory. During July, the company made the following purchases:

July 5: 100 units at $10 per unit
July 15: 150 units at $12 per unit
July 25: 80 units at $15 per unit

Gadget Co. sold 280 units for $25 per unit in July, with no sales returns, allowances, or discounts for the month.

First, determine net sales. With 280 units sold at $25 each, total revenue is $25 \times 280 = \$7,000$. Net sales also equal $7,000.

Next, calculate the Cost of Goods Sold (COGS) using the FIFO method. Gadget Co. sold 280 units, assuming the first units purchased were sold first. The 100 units from July 5 ($10 each) are sold first, totaling $1,000. The next 150 units from July 15 ($12 each) are sold, totaling $1,800. The remaining 30 units (280 – 250) come from the July 25 purchase ($15 each), totaling $450.

Total COGS is $1,000 + $1,800 + $450 = $3,250. Finally, calculate the gross profit by subtracting COGS from net sales. Gross Profit = $7,000 – $3,250 = $3,750. This example demonstrates how FIFO systematically assigns costs from the earliest purchases to the goods sold, directly impacting the gross profit calculation.