How to Use the FIFO Method for Inventory Valuation

The First-In, First-Out (FIFO) method is a widely adopted accounting technique used by businesses to manage and value their inventory. This method plays a significant role in determining the Cost of Goods Sold (COGS) and the value of remaining inventory at the end of an accounting period. FIFO aligns with the natural flow of many businesses, particularly those dealing with perishable goods or items with a limited shelf life. Its application directly influences a company’s reported profitability and the valuation of its assets on financial statements.

Core Principles of FIFO

The FIFO method assumes that the first inventory units purchased or produced are the first ones sold. This principle guides how costs are assigned to products that have been sold, regardless of their actual physical movement. For example, a grocery store sells its oldest milk first, even if a newer carton is physically pulled from the back of the shelf. This cost flow assumption ensures that the costs associated with the earliest inventory are recognized as expenses before the costs of more recently acquired items.

When a sale occurs, the cost assigned to that sale comes from the oldest available inventory. Consequently, the inventory remaining at the end of an accounting period is assumed to be composed of the most recently purchased or produced goods. This approach simplifies inventory valuation and provides a clear framework for financial reporting. The FIFO method aligns with both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it a commonly accepted practice.

Gathering Inventory Data

Applying the FIFO method requires meticulous record-keeping of inventory details. Businesses must track the purchase dates for all inventory units to establish the chronological order of acquisition. Alongside purchase dates, the quantity of units acquired in each purchase and the corresponding unit cost for every acquisition are necessary data points. This information allows for precise cost assignment in the FIFO calculation.

Recording sales dates and quantities sold for each transaction is also important. This sales data helps determine which inventory units, based on their acquisition order, are considered sold under the FIFO assumption. Organizing this information, perhaps in an inventory ledger or spreadsheet, streamlines the calculation of Cost of Goods Sold and ending inventory. Consistent and accurate recording of these transactions is essential for reliable FIFO results.

Applying FIFO to Cost of Goods Sold

Calculating Cost of Goods Sold (COGS) using FIFO involves assigning the costs of the oldest inventory to the units sold. Businesses begin by identifying the earliest purchased units from their inventory data. The cost of these initial units is then allocated to the quantity of goods sold until that entire batch is depleted. If the number of units sold exceeds the quantity in the oldest batch, the calculation proceeds to the next oldest inventory batch until the total quantity sold is accounted for.

This sequential allocation means that the COGS reported will reflect the costs of the inventory that was acquired first. This method ensures that the income statement reflects the costs of the oldest goods assumed to have been sold. In periods of rising prices, using FIFO generally results in a lower COGS because the older, typically less expensive, costs are expensed first.

Applying FIFO to Ending Inventory

Determining the value of ending inventory under the FIFO method involves identifying the units that remain unsold at the close of an accounting period. Since FIFO assumes that the oldest inventory items are sold first, the remaining inventory is composed of the most recently purchased units. To calculate this value, businesses refer to their inventory records and locate purchases not assigned to Cost of Goods Sold.

The total cost of these remaining units is calculated by multiplying their quantities by their original unit costs from the most recent purchases. This approach provides a valuation of inventory on the balance sheet that generally reflects more current market prices, especially in an inflationary environment.

Illustrative Example

Consider a small electronics retailer, “TechGadget,” that sells a specific model of wireless headphones. On January 1, TechGadget had no beginning inventory. During January, the following transactions occurred:
January 5: Purchased 50 headphones at $20 each.
January 12: Purchased 70 headphones at $22 each.
January 20: Sold 80 headphones.
January 25: Purchased 60 headphones at $23 each.

To calculate the Cost of Goods Sold for the 80 headphones sold on January 20, TechGadget applies the FIFO principle. The first 50 headphones sold are assumed to come from the January 5 purchase, costing $20 each. This accounts for $1,000 (50 units $20/unit) of the COGS. The remaining 30 headphones (80 total sold – 50 from first batch) are assumed to come from the next oldest purchase, the January 12 batch. These 30 headphones cost $22 each, adding $660 (30 units $22/unit) to the COGS. Therefore, the total Cost of Goods Sold for January 20 is $1,000 + $660 = $1,660.

Next, TechGadget determines the ending inventory at the end of January. The remaining inventory consists of units that were not sold. From the January 12 purchase, 40 headphones (70 original – 30 sold) remain at $22 each. The entire January 25 purchase of 60 headphones at $23 each also remains. The value of the ending inventory is calculated as (40 units $22/unit) + (60 units $23/unit). This results in $880 + $1,380 = $2,260.