FIFO: What the First In, First Out Method Is and How to Use It

What Is First In, First Out (FIFO)?

First In, First Out, commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first.

For tax purposes, 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 the assets that are most recently purchased or produced.

Understanding the First In, First Out (FIFO) Method

The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense.

Under FIFO, it is assumed that the cost of inventory purchased first will be recognized first. 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 may be calculated in several ways—one being the FIFO method.

Typical economic situations involve inflationary markets and rising prices. In this situation, if FIFO assigns the oldest costs to the cost of goods sold, these oldest costs will theoretically be priced lower than the most recent inventory purchased at current inflated prices.

This lower expense results in higher net income. Also, because the newest inventory was purchased at generally higher prices, the ending inventory balance is inflated.

Example of FIFO

Inventory is assigned costs as items are prepared for sale. This may occur through the purchase of the inventory or production costs, the purchase of materials, and the utilization of labor. These assigned costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first.

Imagine if a company purchased 100 items for $10 each, then later purchased 100 more items for $15 each. Then, the company sold 60 items. Under the FIFO method, the cost of goods sold for each of the 60 items is $10/unit 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. This is because inventory is assigned the most recent cost under the FIFO method.

With this remaining inventory of 140 units, let's say the company sells an additional 50 items. The cost of goods sold for 40 of these 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 (the most recent price paid).

The FIFO method follows the logic that to avoid obsolescence, a company would sell the oldest inventory items first and maintain the newest items in inventory. Although the actual inventory valuation method used does not need to follow the actual flow of inventory through a company, an entity must be able to support why it selected the use of a particular inventory valuation method.

FIFO vs. LIFO

The inventory valuation method opposite to FIFO is LIFO, where the last item purchased or acquired is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory when compared to FIFO.

In many ways, FIFO and LIFO are opposites. Instead of a company selling the first item in inventory, it sells the last. During periods of increasing prices, this means the inventory item sold is assessed a higher cost of good sold under LIFO. As a result, a company's expenses are usually higher in these conditions, meaning net income is lower under LIFO compared to FIFO during inflationary periods.

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

FIFO vs. Other Valuation Methods

Average Cost Inventory

The average cost inventory method assigns the same cost to each item. The average cost method is calculated by dividing the cost of goods in inventory by the total number of items available for sale. This results in net income and ending inventory balances between FIFO and LIFO.

Specific Inventory Tracing

Finally, specific inventory tracing is used when all components attributable to a finished product are known. If all pieces are not known, the use of FIFO, LIFO, or average cost is appropriate.

Advantages and Disadvantages of FIFO

Many businesses prefer the FIFO method because it is easy to understand and implement. This means that statements are more transparent, and it is harder to manipulate FIFO-based accounts to embellish the company's financials. For this reason, FIFO is required in some jurisdictions under the International Financial Reporting Standards, and it is also standard in many other jurisdictions.

Moreover, this method also follows the natural flow of inventory: most businesses prefer to sell their oldest products first, knowing that these are most likely to lose value due to long-term storage. This also means that the company's accounts will better reflect the value of current inventory since the unsold products are also the newest ones.

However, there are some disadvantages. The FIFO method can result in higher income taxes for the company, because there is a wider gap between costs and revenue. This can also result in overstating the company's profits.

Which Inventory Method Should You Use?

In some countries, FIFO is the required accounting method for keeping track of inventory, and it is also popular in countries where it is not mandatory. Because FIFO is considered the more transparent accounting method, it is also less likely to be scrutinized by the tax authorities.

However, there are some advantages to the LIFO method. In jurisdictions that allow it, the LIFO allows companies to list their most recent costs first. Because expenses rise over time, this can result in lower corporate taxes. Because these issues are complex, it is important to raise them with an accountant before changing a company's accounting practices.

The Bottom Line

The First-In-First-Out, or FIFO method, is a standard accounting practice that assumes that assets are sold in the same order that they are bought. In some jurisdictions, all companies are required to use the FIFO method to account for inventory. But even where it is not required, it is a popular standard due to its ease and transparency.