The FIFO Method: First In, First Out

What Is the FIFO Method?

FIFO means "First In, First Out." It's an asset management and valuation method in which older inventory is moved out before new inventory comes in. The first goods to be sold are the first goods purchased.

FIFO assumes that assets with the oldest costs are included in the income statement's Cost of Goods Sold (COGS). The remaining inventory assets are matched to assets that were most recently purchased or produced.

The FIFO method avoids obsolescence by selling the oldest inventory items first and maintaining the newest items in inventory. The actual inventory valuation method used doesn't have to follow the actual flow of inventory through a company but it must be able to support why it selected the inventory valuation method.

How First In, First Out (FIFO) Works

The FIFO method is used for cost flow assumption purposes. The costs associated with manufactured products must be recognized as an expense as items progress to later development stages and finished inventory items are sold. The cost of inventory purchased first will be recognized first under FIFO.

The dollar value of total inventory decreases in this process because inventory has been removed from the company’s ownership. The costs associated with the inventory can be calculated in several ways, one being the FIFO method.

Typical economic situations involve inflationary markets and rising prices. The oldest costs will theoretically be priced lower than the most recent inventory purchased at current inflated prices in this situation if FIFO assigns the oldest costs to the cost of goods sold. This lower expense results in higher net income. The ending inventory balance is inflated.

Example

Inventory is assigned costs as items are prepared for sale and based on the order in which the product was used. It's based on what arrived first for FIFO.

Assume a company purchased 100 items for $10 each and then purchased 100 more items for $15 each. The company sold 60 items. The COGS for each of the 60 items is $10/unit under the FIFO method because the first goods purchased are the first goods sold. Of the 140 remaining items in inventory, the value of 40 items is $10/unit and the value of 100 items is $15/unit because the inventory is assigned the most recent cost under the FIFO method.

The company sells an additional 50 items with this remaining inventory of 140 units. The cost of goods sold for 40 of the items is $10 and the entire first order of 100 units has been fully sold. The other 10 units that are sold have a cost of $15 each and the remaining 90 units in inventory are valued at $15 each or the most recent price paid.

FIFO vs. LIFO

The LIFO inventory valuation method is the opposite of FIFO. The last item purchased or acquired is the first item out. This results in deflated net income costs in inflationary economies and lower ending balances in inventory compared to FIFO. A company sells the last item in inventory instead of the first. The inventory item sold is assessed a higher cost of goods sold under LIFO during periods of increasing prices.

There are balance sheet implications between these two valuation methods. More expensive inventory items are usually sold under LIFO so the more expensive inventory items are kept as inventory on the balance sheet under FIFO. Not only is net income often higher under FIFO but inventory is often larger as well.

Other Valuation Methods

• Average Cost Inventory: The average cost inventory method assigns the same cost to each item. It's calculated by dividing the cost of goods in inventory by the total number of items that are available for sale. This results in net income and ending inventory balances between FIFO and LIFO.
• Specific Inventory Tracing: Specific inventory tracing is used when all components attributable to a finished product are known. FIFO, LIFO, or average cost is appropriate if all pieces are unknown.

Advantages and Disadvantages of FIFO

The FIFO method is easy to understand and to implement. Statements are more transparent and it's more difficult to manipulate FIFO-based accounts to embellish the company's financials. FIFO is required under the International Financial Reporting Standards and it's also standard in many other jurisdictions.

The FIFO method also follows the natural flow of inventory. Most businesses prefer to sell their oldest products first. The company's accounts will better reflect the value of current inventory because the unsold products are also the newest ones.

There are some disadvantages, however. The FIFO method can result in higher income taxes for a company because there's a wider gap between costs and revenue. The alternate method of LIFO allows companies to list their most recent costs first in jurisdictions that allow it. Expenses rise over time so this can result in lower corporate taxes.

The Bottom Line

The First In, First Out FIFO method is a standard accounting practice that assumes that assets are sold in the same order they're bought. All companies are required to use the FIFO method to account for inventory in some jurisdictions but FIFO is a popular standard due to its ease and transparency even where it isn't mandated.