Why Is FIFO the Best Inventory Valuation Method?

Inventory valuation is a fundamental accounting practice that determines the monetary value of a company’s goods for sale. This process directly impacts its financial statements, helping businesses understand profitability, asset base, and overall financial health. Businesses employ various methods to assign a cost to their inventory, each based on different assumptions about how goods move. Among these methods, the First-In, First-Out (FIFO) approach is frequently recognized for its advantages in financial reporting.

Understanding Inventory Valuation Methods

The primary purpose of inventory valuation is to accurately determine the Cost of Goods Sold (COGS) during an accounting period and the value of remaining inventory at period-end. COGS represents the direct costs of goods sold. Ending inventory is reported as a current asset on the balance sheet, reflecting the value of unsold goods. Different valuation methods make distinct assumptions about which units are sold first, even if the physical flow of goods differs.

The three main inventory valuation methods commonly used are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average. FIFO assumes that the first units purchased or produced are the first ones sold. LIFO operates under the assumption that the last units acquired are the first ones sold. The Weighted-Average method calculates an average cost for all available inventory, then applies that average cost to both COGS and ending inventory. Each method has a unique impact on a company’s financial figures, dependent on price fluctuations.

The Mechanics of FIFO

The FIFO method operates on the principle that the oldest inventory items are sold first. This means the cost of goods acquired earliest is expensed as Cost of Goods Sold. The inventory remaining at the end of an accounting period is assumed to consist of the most recently purchased items. This assumption often aligns with the physical flow of goods for many businesses, especially those dealing with perishable items or products with expiry dates.

To illustrate, if a business purchases 10 units at $10 each on January 1st and 10 units at $12 each on January 15th, then sells 15 units on January 20th, FIFO dictates how the cost is assigned. The first 10 units sold are assigned the cost of the January 1st purchase ($10 per unit). The remaining 5 units sold are assigned the cost of the January 15th purchase ($12 per unit). Therefore, the Cost of Goods Sold is (10 units $10) + (5 units $12) = $100 + $60 = $160. The ending inventory consists of the remaining 5 units from the January 15th purchase, valued at $12 each, totaling $60.

FIFO’s Representation of Current Costs

Under the FIFO method, the inventory balance reported on a company’s balance sheet reflects the most recent costs incurred for acquiring goods. This occurs because the method assumes that the oldest, and typically lower-cost, goods are sold first. As a result, the goods that remain in inventory are those purchased or produced more recently. These newer inventory items are generally valued closer to their current market prices or replacement costs. This characteristic provides a more accurate representation of the company’s current assets. Valuing inventory at amounts closely approximating current market values enhances the transparency and reliability of the balance sheet, supporting better decision-making for external users.

Impact on Key Financial Metrics

The FIFO method significantly influences a company’s financial statements, particularly the income statement and balance sheet. In an environment of rising prices, common during inflationary periods, FIFO generally results in a lower Cost of Goods Sold because older, less expensive inventory items are assumed to be sold first. A lower COGS leads to a higher reported gross profit and, consequently, a higher net income for the period. This outcome often appears favorable to investors and can improve various profitability ratios.

Conversely, in a period of falling prices, FIFO results in a higher Cost of Goods Sold, leading to a lower reported gross profit and net income. While FIFO tends to show higher profits during inflation, it also means a company may face higher income tax liabilities, as taxable income is greater. On the balance sheet, FIFO consistently values ending inventory at more current costs, reflecting the most recently purchased items, which helps in evaluating a company’s liquidity and solvency.

Global Accounting Standards and FIFO

The First-In, First-Out method holds a prominent position within international accounting standards. International Financial Reporting Standards (IFRS), adopted by over 140 jurisdictions globally, explicitly mandate the use of either the FIFO method or the Weighted-Average method for inventory valuation. IFRS prohibits the Last-In, First-Out (LIFO) method to enhance comparability and transparency across financial statements of companies operating internationally. While U.S. Generally Accepted Accounting Principles (GAAP) allow companies to choose between FIFO, LIFO, or the Weighted-Average method, the global preference for FIFO due to IFRS makes it a widely accepted and understood approach. Companies that operate globally or seek international investment often find it advantageous to use FIFO to align with international reporting norms, facilitating easier financial statement analysis across different regions.