What Does First-In, First-Out Mean?

First-In, First-Out, commonly known as FIFO, is an accounting method used for cost flow assumption purposes. The principle of FIFO is the assumption that the first units purchased or produced are the first ones to be sold. This concept mirrors the physical flow of goods in many industries, like those with perishable items or products that can become obsolete, where selling older stock first is a logical business practice.

FIFO in Inventory Valuation

For businesses holding inventory, FIFO is a method to calculate the Cost of Goods Sold (COGS) for the income statement and the value of ending inventory for the balance sheet. Under this method, the costs of the earliest acquired inventory are the first to be recognized as COGS, which aligns with the physical movement of products for many companies.

To illustrate, imagine a business makes two inventory purchases in a month: a first purchase of 20 mugs at $4 each, and a second purchase of 30 mugs at $5 each. If the business sells 25 mugs that month, the FIFO calculation for COGS assumes the first 20 mugs sold are from the initial purchase at $4 each. The remaining 5 mugs sold are from the second purchase at $5 each. Therefore, the COGS is calculated as (20 mugs x $4) + (5 mugs x $5), which equals $105. The ending inventory consists of the remaining 25 mugs from the second purchase, valued at $125.

FIFO in Investment Accounting

The first-in, first-out logic also applies to personal investments. When an investor sells a portion of their holdings, they must determine the cost basis of the shares sold to calculate the capital gain or loss for tax purposes. Brokerage firms report these sales on Form 1099-B and must set a default accounting method. While FIFO is a common default for stocks, other methods like average cost are often the default for mutual funds. Investors can choose a different method if they do so before the sale of the security is settled.

Consider an investor who buys shares on two different dates. They first purchase 10 shares at $100 per share and later buy another 10 shares at $120 per share. If the investor decides to sell 15 shares when the market price is $150, the FIFO method dictates which shares are sold. The first 10 shares sold are assumed to be from the initial purchase at $100 each, and the next 5 shares are from the second purchase at $120 each. The total cost basis for the sale is ($100 x 10) + ($120 x 5), or $1,600, and the capital gain is the total proceeds of $2,250 minus this cost basis, resulting in a taxable gain of $650.

Financial Statement and Tax Implications

The choice of the FIFO method has direct consequences on a company’s financial statements and tax liability, especially in an inflationary environment where costs are rising. When a company uses FIFO during periods of increasing prices, it expenses the older, lower-cost inventory first. This practice results in a lower reported Cost of Goods Sold.

A lower COGS leads to a higher gross profit and reported net income. While higher profits can appear favorable to investors and lenders, they also mean the company will report higher taxable income, leading to a greater income tax obligation.

The inventory value reported on the company’s balance sheet will also be higher under FIFO in a rising cost scenario. This is because the remaining inventory is valued at the most recent, higher purchase prices. This higher valuation presents a more current picture of the inventory’s replacement cost, making the balance sheet appear stronger.