How to Use the FIFO Method in Accounting

The First-In, First-Out (FIFO) method is an inventory valuation technique used by businesses. It assumes that the first inventory items acquired are the first ones sold, which helps accurately reflect the cost of goods sold and the value of remaining inventory on financial statements.

Understanding the FIFO Concept

The core principle of the FIFO method is the assumption that the first inventory items purchased or produced are the first ones sold. This means that for accounting purposes, the oldest costs are assigned to items leaving inventory, even if physical movement differs. This concept is similar to how a dairy store manages milk, selling older cartons first.

Applying FIFO directly influences a business’s Cost of Goods Sold (COGS) and the valuation of its ending inventory. When older, lower costs are assigned to COGS during periods of rising prices, reported profit tends to be higher. Conversely, ending inventory is valued using the most recent, higher costs, providing a more current representation of asset value on the balance sheet. Many businesses, especially those with perishable goods, find FIFO aligns well with their actual physical inventory flow.

Gathering and Organizing Data for Calculation

Before any FIFO calculation, a business must meticulously gather and organize specific inventory data. This step ensures accuracy. Essential information includes the date of each inventory purchase, the quantity of units acquired, and the cost per unit.

Similarly, for every sale transaction, the business needs to record the date of sale and the total quantity of units sold. Maintaining accurate records for both acquisitions and sales is crucial. Businesses often utilize spreadsheets, dedicated inventory management software, or enterprise resource planning (ERP) systems to track this information. A consistent system for data entry ensures all necessary details are available for calculations.

Executing the FIFO Calculation

With all necessary purchase and sales data organized, the next step involves systematically applying the FIFO method to determine both Cost of Goods Sold (COGS) and ending inventory value. This process requires a sequential approach, matching sales to the oldest available inventory costs. For instance, consider a business made two purchases: 10 units at $10 each on January 5th, and 15 units at $12 each on January 15th.

If the business sells 12 units on January 20th, FIFO dictates the first 10 units sold are assigned the cost of $10 each from the January 5th purchase. The remaining 2 units sold are assigned the cost of $12 each from the January 15th purchase. The Cost of Goods Sold for this sale is calculated as (10 units $10) + (2 units $12), totaling $124. This calculation reflects the assumption that oldest goods are expensed first.

To determine ending inventory, identify remaining units after sales. In the example, 13 units remain from the January 15th purchase (15 units purchased – 2 units sold). These units are valued at their original purchase cost of $12 per unit. The ending inventory value is 13 units multiplied by $12, resulting in $156.

Applying FIFO in Business Operations

Implementing the FIFO method influences a business’s financial reporting and operational decisions. Consistent application directly impacts a company’s financial statements, particularly the income statement and balance sheet. On the income statement, FIFO determines the reported Cost of Goods Sold, which affects gross profit and ultimately net income.

On the balance sheet, FIFO dictates inventory valuation, presenting a more current cost for remaining goods during inflation. This can influence financial ratios and provide management with insights into profit margins and pricing strategies. Maintaining diligent record-keeping of all inventory movements is necessary for accurate FIFO calculations over time. Adhering to this method consistently ensures compliance with accounting standards and provides a clear view of a business’s financial performance.