What Is the FIFO Accounting Method?

What Is FIFO?

FIFO is an acronym for First In, First Out.

It is a method used for organizing and managing data so that the first piece of data to be inputted is also the first to be outputted.

For example, let’s say you have a FIFO queue of tasks to do.

The first task on the queue (the “first in”) would be the first one you work on (the “first out”).

You would only start working on the second task once you’ve finished the first one, and so on.

This ensures that the tasks are completed in the order they were received.

 

Understanding First In, First Out (FIFO)

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

The purpose of FIFO is to match revenues with the expenses incurred in acquiring the inventory.

FIFO assumes that there is a continuous flow of identical units into and out of inventory.

FIFO calculation results in lower ending inventory values than the other costing methods (LIFO and weighted average).

Therefore, FIFO generally results in higher income taxes due because taxable income is higher.

FIFO can also result in distorted unit costs if there are large swings in prices during the period.

The FIFO method is often used in situations where inventory levels are constantly changing, such as in retail or manufacturing environments.

FIFO is also the preferred method for valuing inventory for financial reporting purposes in most jurisdictions.

 

Example of FIFO

To illustrate, assume a company buys 500 units of inventory at $5.

During the period, the company acquires an additional 1,000 units at a cost of $6 each. The company then sells 1,200 units during the period at a selling price of $10 each.

Under FIFO, the 500 units from the beginning of the period are assumed to be sold first.

The cost of goods sold then needs to dip into the 1,000 units acquired during the current period at a cost of $6 each since 1,200 total were sold.

Therefore, the cost of goods sold is 500 * $5 + 700 * $6 ($2,500 + $4,200), which is $6,700.

The ending inventory balance consists of the 300 units that were not sold during the period.

These units were acquired at a cost of $6 each using FIFO, so the ending inventory value is $1,800 (300 x $6).

The company’s gross profit would be calculated as follows:

Gross profit = Sales – Cost of goods sold

Gross profit = 1,200 units x $10 per unit – $6,700 = $12,000 – $6,700 = $5,300

 

FIFO vs. Other Valuation Methods

There are multiple other valuation methods for inventory:

LIFO – Last In, First Out

Under the LIFO method, inventory is valued at the cost of the most recent units acquired.

In the above example, the cost of goods sold would be calculated by first using the 1,000 units acquired during the current period at a cost of $6 each since they were the last in.

Then you’d dip into the next set of units (200 units).

The ending inventory value would consist of the 300 units on hand at the beginning of the period, which were acquired at a cost of $5 each.

The company’s gross profit would be calculated as follows:

Gross profit = Sales – Cost of goods sold

Gross profit = 1,200 units x $10 per unit – 1,000 units x $6 per unit – 200 units x $5 per unit = $12,000 – $6,000 – $1,000 = $5,000

Average Inventory Cost – Weighted Average

Under the weighted average method, the cost of goods sold is calculated using a weighted average of the units on hand at the beginning of the period and the units acquired during the period.

In the above example, the cost of goods sold would be calculated as follows:

Cost of goods sold = (500 units x $5 per unit + 1,000 units x $6 per unit) / 1,500 units

Cost of goods sold = $8,500 / 1,500

Cost of goods sold = $5.67 per unit

Gross profit = 1,200 units x $10 per unit – 1,200 units x $5.67 per unit = $12,000 – $6,804 = $5,196

The ending inventory value would also be calculated using a weighted average of the cost of the units on hand at the beginning of the period and the units acquired during the period.

Specific Inventory Tracing – Specific Identification

Under the specific identification method, each unit of inventory is traced back to its original cost.

This method is used in cases where it is possible to physically identify each unit of inventory, such as with unique serial numbers.

 

FIFO – FAQs

When Is First In, First Out (FIFO) Used?

FIFO is used in most cases because it provides the closest approximation to the actual flow of inventory.

FIFO also generally results in a lower taxable income, since the cost of goods sold is based on the oldest units of inventory, which are usually the ones that were acquired at the highest cost.

What Are the Advantages of First In, First Out (FIFO)?

The main advantage of FIFO is that it provides a more accurate representation of the actual flow of inventory.

FIFO also generally results in a lower taxable income, since the cost of goods sold is based on the oldest units of inventory, which are usually the ones that were acquired at the highest cost.

What Are the Disadvantages of First In, First Out (FIFO)?

The main disadvantage of FIFO is that it may not always provide the most accurate representation of the actual flow of inventory.

For example, if a company acquires a large quantity of inventory at a low cost and then sells a smaller quantity of inventory at a higher cost, FIFO will result in a higher cost of goods sold and a lower gross profit.

How Do I Choose the Right Inventory Method?

There is no one right answer for choosing the best inventory valuation method.

The method that you choose should be based on your company’s specific needs and goals.

If you are looking for a more accurate representation of inventory, FIFO may be the best choice.

However, if you are looking to minimize taxable income, LIFO may be a better option.

Ultimately, the decision should be made based on what will provide the most accurate financial picture for your company.

No matter which inventory valuation method you choose, it is important to be consistent in your application of the chosen method.

Once you have chosen a method, stick with it and do not switch back and forth between methods. This will help to ensure that your financial statements are accurate and reliable.

What Other Inventory Valuation Methods Are Available?

In addition to FIFO, there are a few other inventory valuation methods that are commonly used. These include:

LIFO – Last in, first out. Under this method, the last units of inventory to be acquired are assumed to be the first units sold.

Weighted average – Under this method, the cost of goods sold is based on a weighted average of the cost of all units of inventory on hand.

Specific identification – Under this method, each unit of inventory is traced back to its original cost. This method is used in cases where it is possible to physically identify each unit of inventory, such as with unique serial numbers.

FIFO vs. LIFO Inventory Accounting

Does US GAAP Prefer FIFO or LIFO?

Under GAAP, companies can choose among three different ways to report cost flow assumptions for inventory.

They can use FIFO, LIFO, or can calculate inventory costs via the average cost method.

On the other hand, companies reporting under International Financial Reporting Standards (IFRS) may use only FIFO.

 

Summary – FIFO

FIFO is an inventory valuation method in which the earliest produced items are recorded as sold first.

The assumption made with FIFO is that the most recent items produced are still in stock, and therefore have not yet been sold.

FIFO stands for “First In, First Out” and is used in situations where inventory is perishable or has a specific expiration date.

Under the FIFO method, the cost of goods sold is based on the cost of the earliest purchased or manufactured goods that have not yet been sold.

The remaining inventory on hand consists of the most recently purchased or manufactured goods.

If prices are rising, FIFO results in a lower cost of goods sold than would be the case if another inventory valuation method, such as LIFO (last in, first out) were used.

As a result, FIFO also results in a higher taxable income.

FIFO is the most commonly used inventory valuation method because it more closely resembles the actual physical flow of inventory than any other method.

The main advantage of using FIFO is that it more accurately reflects the cost of goods sold since the earliest purchased items are assumed to have been sold first.

This is especially important in industries where inventory turnover is high and prices are constantly changing, such as the food and beverage industry.

A disadvantage of FIFO is that it can result in less tax efficiency than other inventory valuation methods, such as LIFO.

This is because FIFO results in a higher cost of goods sold, and therefore a higher taxable income.

 

 

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