What Is the FIFO Inventory Method and How Does It Work?

Inventory is a significant asset for many businesses, representing goods available for sale. Accurately accounting for this inventory is crucial for reporting a company’s financial performance and position. It directly impacts key financial statements, including the income statement and the balance sheet. One widely used method for valuing inventory and the associated cost of goods sold is the First-In, First-Out (FIFO) method. This approach provides a structured way to track the flow of costs through a business’s operations.

The FIFO Principle

FIFO stands for “First-In, First-Out,” an inventory valuation method. This principle operates on the assumption that the first inventory items acquired or produced are the first ones sold or expensed. For instance, a grocery store stocks milk with the earliest expiration dates at the front, ensuring those cartons are sold before newer ones. A bakery sells bread baked earlier in the day before selling newer bread.

FIFO is an accounting assumption regarding cost flow, not necessarily a reflection of the physical movement of every item. While many businesses, especially those with perishable goods, do physically move older inventory first, the FIFO accounting method applies this assumption consistently. This method ensures that the costs associated with the oldest inventory are recognized as expenses when sales occur, while the costs of the most recently acquired items remain in the inventory balance. This approach often aligns with the natural operational flow of goods for many businesses.

Applying the FIFO Calculation

Calculating both the Cost of Goods Sold (COGS) and the value of ending inventory using the FIFO method involves tracking the costs of inventory layers. The COGS represents the direct costs attributable to the production of goods sold by a company, while ending inventory is the value of goods remaining unsold at the end of an accounting period. The basic formula for COGS is: Beginning Inventory + Purchases – Ending Inventory. Conversely, Ending Inventory = Beginning Inventory + Purchases – COGS.

To illustrate, consider this inventory activity:
Beginning Inventory: 100 units at $10 each.
Purchase 1: 50 units at $12 each.
Purchase 2: 50 units at $14 each.

If 120 units are sold, the FIFO calculation for COGS starts with the oldest units. The first 100 units sold are from the beginning inventory at $10 each ($1,000). The remaining 20 units sold (120 total units sold – 100 units from beginning inventory) come from Purchase 1 at $12 each ($240). Total COGS is $1,240 ($1,000 + $240).

To determine ending inventory, consider the most recently purchased unsold units. 30 units remain from Purchase 1 (50 units – 20 units sold) at $12 each, valuing $360. All 50 units from Purchase 2 at $14 each, valuing $700, also remain. Thus, ending inventory is $1,060 ($360 + $700).

FIFO’s Impact on Financial Statements

The application of the FIFO method directly influences a company’s financial statements, particularly the income statement and the balance sheet. On the income statement, FIFO affects the Cost of Goods Sold (COGS) and, consequently, the Gross Profit. On the balance sheet, it impacts the value of Ending Inventory.

During periods of rising costs, also known as inflation, FIFO generally results in a lower COGS because it assumes the older, less expensive inventory is sold first. This lower COGS leads to a higher reported Gross Profit and, subsequently, a higher net income. Simultaneously, the ending inventory reported on the balance sheet tends to be higher under FIFO during inflation, as it consists of the more recently purchased, higher-cost items.

Conversely, in a deflationary environment where costs are falling, FIFO allocates a higher amount to COGS because the older, more expensive inventory is assumed to be sold. This results in a lower Gross Profit and net income. The ending inventory balance would then be lower, reflecting the decreasing costs of newer inventory. Generally Accepted Accounting Principles (GAAP) require companies to disclose the inventory method used in their financial statements and adhere to it consistently, unless there is a justifiable reason for a change.

Real-World Use of FIFO

The FIFO inventory method is a common and logical choice for many businesses, especially those whose physical inventory flow naturally matches the first-in, first-out assumption. Companies dealing with perishable goods, such as food and beverage retailers or pharmaceutical manufacturers, frequently use FIFO. For these businesses, selling older products first is essential to prevent spoilage, expiration, or obsolescence, which aligns perfectly with the FIFO principle.

Beyond perishable items, businesses selling high-turnover products or items subject to rapid fashion changes, like clothing or electronics, also find FIFO suitable. This method ensures that older styles or models are accounted for as sold before newer ones, reflecting the actual movement of goods and reducing the risk of holding outdated inventory. The alignment of FIFO with the physical flow of goods in these industries makes it a practical and intuitive method for inventory valuation and cost accounting.