How to Calculate the First-In, First-Out Method

Inventory costing methods are fundamental accounting practices used to determine the monetary value of goods sold and remaining merchandise. They help businesses accurately report financial performance and asset valuations. Among various approaches, the First-In, First-Out (FIFO) method is a widely adopted technique for valuing inventory and calculating the cost of goods sold. Understanding this method helps businesses maintain accurate financial records and prepare reliable statements.

Understanding the FIFO Principle

The First-In, First-Out (FIFO) principle assumes that the first units of inventory acquired are the first ones to be sold. When a sale occurs, the cost assigned to it comes from the oldest available inventory units. The method focuses on the flow of costs, not necessarily the physical movement of goods. While products like fresh produce or pharmaceuticals often physically move in a FIFO manner due to spoilage, the accounting principle applies broadly to all types of inventory.

This cost flow assumption dictates that earliest purchase costs are matched against sales revenue. Inventory remaining at the end of an accounting period is assumed to consist of the most recently acquired units. The FIFO method can impact a company’s reported profit and the value of its assets on the balance sheet. It provides a structured way to account for inventory, particularly in environments with fluctuating purchase prices.

Gathering Necessary Inventory Data

Accurate application of the FIFO method relies on meticulously maintained inventory records. Businesses must gather specific data points for precise calculations. This includes details about beginning inventory: goods on hand at the start of the accounting period and their associated costs. These initial units form the first layer of inventory available for sale.

Beyond the beginning inventory, all purchases made throughout the period require careful documentation. For each purchase, the date of acquisition, the exact number of units bought, and the cost per unit must be recorded. These purchase records establish successive layers of inventory, each with its own specific cost. Finally, the total units sold during the period are also necessary. Without precise and detailed records of these inventory transactions, accurate FIFO calculations are not possible.

Calculating Cost of Goods Sold and Ending Inventory

Applying the FIFO method involves a two-step process to determine cost of goods sold (COGS) and the value of ending inventory. To calculate COGS, units sold are assumed to come from the earliest inventory layers available. This means costs of the oldest units—beginning inventory and then first purchases—are systematically assigned to units sold. For example, if 100 units were sold, and the beginning inventory had 50 units, those 50 units’ costs are assigned first, followed by costs from the next oldest purchase layer for the remaining 50 units.

After assigning costs to sold units, the remaining inventory units are valued using the costs of the most recent purchases. The units left on hand are presumed to be those acquired last. Ending inventory valuation reflects the costs of the latest inventory layers. This approach ensures that the balance sheet presents inventory at costs that closely reflect current market prices, especially during periods of inflation. The process requires careful tracking of unit quantities and costs from each acquisition date to ensure proper allocation.

Practical Calculation Example

Consider a business that began an accounting period with 100 units of inventory, each costing $10. During the period, the business made two purchases: 150 units at $12 each on March 10, and 200 units at $14 each on April 20. If the business sold 300 units, the FIFO method dictates how the cost of these sold units and the value of remaining inventory are determined.

To calculate the cost of goods sold, the first 100 units sold are assigned the cost of the beginning inventory, totaling $1,000 (100 units x $10). The next 150 units sold are assigned the cost from the first purchase layer, totaling $1,800 (150 units x $12). The remaining 50 units to reach 300 units sold are taken from the second purchase layer, costing $700 (50 units x $14). The total cost of goods sold for the period is $3,500 ($1,000 + $1,800 + $700).

Ending inventory consists of the units not yet sold, which are assumed to be from the most recent purchases. Since 50 units were taken from the 200 units purchased on April 20, 150 units from that layer remain. These 150 units are valued at their purchase cost of $14. Thus, the ending inventory is valued at $2,100 (150 units x $14). This example illustrates how FIFO systematically uses the oldest costs for sales and the newest costs for remaining inventory.