What Is the FIFO Method in Accounting?

Understanding Inventory Costing Methods

Businesses that sell products must account for the cost of goods they purchase or produce and then sell. Inventory costing methods provide a structured way to assign a monetary value to items that are sold and those that remain in stock. These methods are fundamental for accurate financial reporting and for calculating a company’s profitability.

The proper application of an inventory costing method directly influences a business’s reported cost of goods sold and the valuation of its remaining inventory. These figures then impact other financial statement elements, including gross profit and net income. Consistently applying a suitable inventory costing method is an important decision for any business managing its financial records.

Understanding First-In, First-Out

The First-In, First-Out (FIFO) method operates on the assumption that the first units of inventory acquired by a business are the first ones to be sold or used. This means that when a sale occurs, the cost assigned to that sale is based on the cost of the oldest inventory items in stock.

It is important to understand that FIFO is a cost flow assumption, meaning it dictates how costs are matched with revenues, not necessarily the physical movement of goods. While it often aligns with the physical flow for perishable items or products with expiration dates, it is an accounting convention. Under this method, the Cost of Goods Sold (COGS) reflects the cost of the earliest inventory, while the value of Ending Inventory is composed of the costs of the most recently purchased items.

Applying the FIFO Method

Applying the FIFO method involves tracking inventory purchases and sales to determine the cost of items sold and the value of remaining stock. This process assumes that the costs associated with the earliest acquired goods are expensed first when sales occur.

Consider a scenario where a company has the following inventory purchases: On January 5, 100 units were purchased at $10.00 each, and on January 15, an additional 150 units were acquired at $12.00 each. If the company then sells 200 units on January 20, the FIFO method dictates how these costs are assigned. The cost of the first 100 units sold would be from the January 5 purchase, totaling $1,000 (100 units × $10.00).

The remaining 100 units of the 200 sold would then come from the next oldest batch, which is the January 15 purchase. These 100 units would be costed at $12.00 each, amounting to $1,200. Therefore, the total Cost of Goods Sold for the 200 units sold would be $2,200 ($1,000 + $1,200).

To determine the value of ending inventory, we account for the units remaining. After selling 200 units from a total of 250 units purchased (100 + 150), there are 50 units left in stock. Under FIFO, these 50 units are considered to be from the most recent purchase. Since the last purchase was 150 units at $12.00 each, the 50 remaining units are valued at this most recent cost. Consequently, the ending inventory would be valued at $600 (50 units × $12.00). This shows that the inventory remaining on the balance sheet is valued at costs that closely reflect current market prices.

Implications of FIFO

The FIFO method affects a company’s financial statements, particularly profitability and asset valuation. During periods of rising inventory costs, which is common during inflation, FIFO generally results in a lower Cost of Goods Sold (COGS). This occurs because the cheaper, older inventory costs are expensed first.

A lower COGS leads to a higher reported gross profit and, consequently, a higher net income. Simultaneously, the ending inventory value under FIFO will be higher, as it consists of the most recently purchased, and thus more expensive, items. This means the inventory value reported on the balance sheet more closely approximates current replacement costs.

Conversely, in periods of falling costs, FIFO would result in a higher COGS and lower reported net income, with a lower ending inventory value. Companies often choose FIFO because it frequently aligns with the actual physical flow of goods, especially for businesses dealing with perishable products or those where stock rotation is important. Furthermore, it is a widely accepted method under various accounting standards, including the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) in the United States.