What Does the Acronym FIFO Mean in Accounting?

The FIFO Principle

The acronym FIFO stands for “First-In, First-Out,” representing a fundamental inventory costing method in accounting. This method assumes that the first goods purchased or produced are also the first ones sold or used. Businesses widely employ this concept for managing inventory and determining the cost of goods sold. It is particularly relevant for companies handling physical products, providing a structured way to account for the flow of goods and influencing how they track stock value.

Core Concept and Physical Flow

The core concept of FIFO is that the oldest inventory items are the first to leave. When a sale occurs, the cost assigned is that of the earliest acquired goods, and the remaining inventory consists of the most recently purchased items. This often mirrors the actual physical flow for many businesses, especially those dealing with perishable items or products with a limited shelf life. Applying FIFO ensures that a business accounts for the sale of its older stock before it becomes obsolete or expires.

Imagine a stack of newspapers delivered daily; the newspaper at the top of the stack (the first one placed there) is typically the first one picked up by a customer. Similarly, in a grocery store, milk cartons with earlier expiration dates are usually placed at the front of the shelf to be sold first. This physical movement of goods often aligns naturally with the FIFO principle.

Applying FIFO in Inventory

Applying the FIFO principle in inventory management involves determining the Cost of Goods Sold (COGS) and the value of ending inventory. COGS represents the direct costs attributable to the production of the goods sold by a company, while ending inventory is the value of goods still available for sale at the end of an accounting period.

To illustrate, consider a business that sells widgets. On January 1, it purchased 100 widgets at $10 each. Then, on January 15, it acquired another 150 widgets at $12 each. If the business sold 180 widgets during January, the FIFO method would assume that the first 100 widgets sold came from the January 1 purchase at $10 each, totaling $1,000.

The remaining 80 widgets sold would then be assumed to come from the January 15 purchase at $12 each, costing $960. Therefore, the total Cost of Goods Sold for January would be $1,000 + $960 = $1,960. The ending inventory would consist of the remaining 70 widgets from the January 15 purchase (150 – 80 = 70) valued at $12 each, totaling $840.

FIFO’s Impact on Financial Reporting

The application of FIFO directly influences a company’s financial statements, particularly the income statement and the balance sheet. On the income statement, FIFO affects the reported Cost of Goods Sold (COGS) and, consequently, the gross profit and net income. Since it assumes the oldest, typically lower-cost inventory is sold first, FIFO generally results in a lower COGS during periods of rising costs.

A lower COGS leads to a higher reported gross profit and, subsequently, a higher net income. This can present a favorable view of a company’s profitability. Conversely, during periods of falling costs or deflation, FIFO would assign the older, higher costs to COGS, resulting in a higher COGS and thus a lower reported gross profit and net income.

On the balance sheet, FIFO impacts the valuation of ending inventory. In an environment of rising costs, the ending inventory under FIFO is valued using the most recent, higher purchase prices. This results in a higher reported inventory value on the balance sheet, which can enhance the appearance of a company’s assets. In a deflationary period, the ending inventory would reflect the more recent, lower costs, leading to a lower inventory valuation.