What Does the Acronym FIFO Stand For?
Understand FIFO (First-In, First-Out), a key inventory method. Learn its practical application and how it shapes business financial reporting.
Understanding First-In, First-Out
FIFO, or First-In, First-Out, is a common inventory valuation method. This method assumes that the oldest inventory items acquired are the first ones to be sold or used. It reflects the natural flow of many businesses where older goods are moved out before newer ones to prevent spoilage, obsolescence, or manage storage efficiently.
A bakery bakes fresh bread daily. The loaves baked early in the morning are placed at the front of the display and sold before the loaves baked later in the day. This mirrors the FIFO principle, where items acquired first are expensed as cost of goods sold.
How FIFO Works in Practice
Applying the FIFO method involves tracking the cost of specific inventory units. When a business sells goods, it assumes those sold items correspond to the earliest purchased inventory. This process directly impacts the calculation of Cost of Goods Sold (COGS) on a company’s income statement.
An electronics retailer purchases 10 headphones at $50 each on January 1st and another 10 headphones at $60 each on January 15th. If the retailer sells 15 headphones on January 20th, using FIFO, the Cost of Goods Sold would be calculated based on the first 10 headphones purchased at $50 each ($500 total) and 5 of the headphones purchased at $60 each ($300 total). This results in a total COGS of $800 ($500 + $300). The remaining 5 headphones from the January 15th purchase, valued at $60 each, would constitute the ending inventory, totaling $300.
The Impact of Using FIFO
The selection of an inventory valuation method impacts a company’s financial statements. Since FIFO assumes the oldest costs are expensed first, in periods of rising prices (inflation), it results in a lower Cost of Goods Sold. This lower COGS leads to a higher reported gross profit and, consequently, a higher taxable income.
Conversely, during periods of declining prices (deflation), FIFO yields a higher Cost of Goods Sold, leading to a lower gross profit and reduced taxable income. The ending inventory under FIFO reflects the most recent costs, which is closer to current market values during inflationary times. This presents a more current representation of asset values on the balance sheet.