How to Do the FIFO Method for Inventory

The First-In, First-Out (FIFO) method is an accounting technique for managing inventory and determining the cost of goods sold. It assumes that the first items purchased or produced are also the first ones sold or used. Understanding FIFO is important for businesses as it directly impacts financial statements, including profitability and inventory valuation. It provides a structured way to track the flow of goods.

Understanding FIFO Principles

FIFO, or “First In, First Out,” assumes the oldest inventory items are sold first. This method reflects a natural flow for many businesses, as companies often sell their earliest acquired goods to prevent obsolescence or spoilage. The costs associated with the earliest purchased items are recognized as expenses first.

This method is commonly applied in industries where products have a limited shelf life or are subject to rapid changes, such as food and beverage, pharmaceuticals, and fashion. For example, a grocery store arranges milk cartons so those with earlier expiration dates are at the front, ensuring they are sold before newer stock. While FIFO assumes a specific cost flow, the physical movement of goods does not necessarily match this assumption.

To implement FIFO accurately, businesses need detailed records of all inventory transactions, including the date, quantity, and unit cost of each purchase and sale. Maintaining these data points allows for the correct assignment of costs when calculating both the cost of goods sold and the value of remaining inventory.

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 units to the items that have been sold. The goal is to match the revenue generated from sales with the cost of the oldest inventory available.

To perform this calculation, a business identifies the total number of units sold during a period. It then allocates costs to these sold units by drawing from the oldest available inventory layers first, in chronological order of purchase. If the number of units sold exceeds the quantity in the oldest layer, costs are drawn from the next oldest layer until all sold units are accounted for.

Consider an example: A company has the following inventory purchases: 100 units at $10 each on January 1, and 150 units at $12 each on January 15. If the company sells 120 units, the COGS calculation using FIFO would proceed as follows.

The first 100 units sold are assigned the cost of $10 each from the January 1 purchase, totaling $1,000 (100 units x $10/unit). The remaining 20 units sold (120 – 100) are then assigned the cost of $12 each from the January 15 purchase, totaling $240 (20 units x $12/unit).

Therefore, the total COGS for the 120 units sold is $1,000 + $240 = $1,240. This sequential assignment ensures that the oldest costs are expensed first, directly impacting reported profitability.

Determining Ending Inventory Value with FIFO

Determining the value of ending inventory using the FIFO method involves identifying the costs of the most recently purchased inventory units that remain unsold at the end of an accounting period. Since FIFO assumes the oldest goods are sold first, the inventory on hand consists of the newest acquisitions. This valuation provides a representation of inventory at costs closer to current market prices.

To calculate ending inventory, a business first determines the total number of units remaining. These units are then assigned costs by starting with the most recent purchases and working backward chronologically until all units in ending inventory are costed. This approach complements the COGS calculation, as units not expensed as sold are valued as remaining inventory.

Using the previous example, where 100 units were purchased at $10 on January 1 and 150 units at $12 on January 15, and 120 units were sold: The total units available for sale were 250 (100 + 150). After selling 120 units, 130 units remain (250 – 120).

To value these 130 remaining units under FIFO, we assign costs from the most recent purchases. Since 150 units were purchased on January 15 at $12 each, the 130 remaining units are valued at $12 each, totaling $1,560 (130 units x $12/unit).

This remaining inventory value reflects the cost of the latest goods, providing a clear picture of the assets still held by the business. The total cost of goods available for sale (Beginning Inventory + Purchases) should always reconcile with the sum of COGS and ending inventory.

FIFO Application Across Inventory Systems

The application of the FIFO method varies depending on the inventory accounting system a business employs: periodic or perpetual. Both systems can use FIFO, but they differ in when and how frequently inventory records and calculations are updated. Consistent application of the chosen inventory method is important for financial reporting purposes, aligning with Generally Accepted Accounting Principles (GAAP).

Under a periodic inventory system, inventory counts and valuations, including COGS and ending inventory, are performed at the end of an accounting period. Businesses using this system do not continuously track inventory levels; instead, they rely on a physical count or estimate at period-end to determine what was sold and what remains. The FIFO calculation in a periodic system applies the first-in, first-out assumption to the total goods available for sale during the entire period.

Conversely, a perpetual inventory system continuously updates inventory records with each purchase and sale transaction. This means COGS is calculated and recorded immediately after each sale, and inventory balances are adjusted in real-time. For FIFO under a perpetual system, the cost of the oldest units is assigned to each sale as it occurs. While the timing of calculations differs, the final figures for COGS and ending inventory under FIFO generally remain the same whether a periodic or perpetual system is used. Accurate and consistent record-keeping is essential for both systems to ensure the correct application of FIFO and reliable financial reporting.