How to Calculate Inventory Costs With the FIFO Method

The First-In, First-Out (FIFO) method is a widely used accounting technique for valuing inventory. It operates on the principle that the first goods purchased or produced by a business are the first ones to be sold. This method is fundamental for accurately determining both the cost of goods sold (COGS) and the value of remaining inventory at the end of an accounting period. Businesses employ FIFO to reflect a logical flow of goods, particularly for items with a limited shelf life or those where older stock should be moved first.

Understanding the FIFO Principle

The core concept of FIFO, or First-In, First-Out, assumes that the inventory acquired earliest is also the first to be expensed as goods are sold. This is a cost flow assumption, meaning it dictates how costs are matched with revenues, rather than necessarily mirroring the physical movement of every single item. For instance, consider a bakery that bakes fresh bread daily; the loaves baked first are typically sold first to ensure customers receive the freshest product. This physical flow aligns naturally with the FIFO cost flow assumption.

This method is particularly useful for businesses dealing with perishable goods, such as food items, or products subject to rapid technological obsolescence, like electronics. By assuming the oldest costs are recognized first, FIFO helps businesses present a balance sheet where the ending inventory reflects the most recent purchase prices. While it is an assumption for accounting purposes, FIFO often aligns with the practical inventory management strategies aimed at minimizing spoilage or outdated stock.

Gathering Essential Inventory Data

Accurate application of the FIFO method relies heavily on meticulous record-keeping of all inventory movements. Businesses must maintain detailed purchase records, which include the specific date of each purchase, the exact quantity of units acquired in that purchase, and the precise cost per unit for that batch. For example, if a business buys 100 units at $5 each on January 1st and then another 150 units at $6 each on January 15th, these distinct cost layers must be clearly documented. This detailed breakdown is crucial because FIFO assigns costs based on the chronological order of acquisition.

Equally important are comprehensive sales records, noting the date of each sale and the quantity of units sold in each transaction. Knowing the exact number of units sold allows a business to determine how many units from the oldest available stock should have their costs allocated to the cost of goods sold. Without these precise dates and quantities for both purchases and sales, it becomes impossible to correctly apply the “first in, first out” assumption. The integrity of the FIFO calculation directly depends on the granularity and accuracy of this underlying inventory data.

Calculating Cost of Goods Sold with FIFO

Calculating the Cost of Goods Sold (COGS) using the FIFO method involves assigning the costs of the earliest purchased inventory to the units that have been sold. This process systematically matches the oldest costs with the revenue generated from sales. For example, consider a business with the following inventory purchases: 100 units bought on January 1st at $10 each, and 150 units bought on January 15th at $12 each. If the business then sells 120 units during the month, the FIFO calculation begins by assuming the first units sold are from the oldest stock.

To determine the COGS for the 120 units sold, the first 100 units would be costed at $10 each, totaling $1,000. The remaining 20 units (120 total units sold minus the 100 units from the first batch) would then be costed from the next oldest batch, which is the January 15th purchase. Therefore, these 20 units would be costed at $12 each, amounting to $240. The total Cost of Goods Sold for the 120 units would be the sum of these amounts: $1,000 plus $240, resulting in a COGS of $1,240.

Determining Ending Inventory Value with FIFO

Determining the value of ending inventory under the FIFO method involves assigning the costs of the most recently purchased goods to the units that remain unsold at the end of an accounting period. This is a direct consequence of the FIFO assumption, where the oldest inventory costs are expensed first, leaving the newer, and often higher, costs in inventory. Continuing with the previous example, after selling 120 units from an initial stock of 100 units at $10 and 150 units at $12, the remaining inventory needs to be valued.

The initial purchases totaled 250 units (100 + 150). With 120 units sold, 130 units remain in ending inventory. Since the first 100 units (at $10) and 20 units from the second batch (at $12) were considered sold for COGS, the remaining 130 units must come from the most recent purchases. Specifically, all 100 units from the first batch were expensed, and 20 units from the second batch were expensed. This leaves 130 units (150 – 20) from the January 15th purchase, which were acquired at $12 each. Therefore, the value of the ending inventory would be 130 units multiplied by $12 per unit, equaling $1,560.