FIFO, or First In, First Out, is an inventory valuation method used in accounting and finance. This method assumes that the oldest inventory items are sold first, while the newer inventory remains in stock. This approach affects the cost of goods sold (COGS) and ultimately impacts net income, taxes, and inventory valuation on the balance sheet.
Definition and Explanation
FIFO stands for “First In, First Out,” an inventory management method where assets produced or acquired first are used, sold, or disposed of first. In a FIFO inventory system, the costs associated with the inventory that was purchased first are the first to be recorded as Cost of Goods Sold (COGS). Meanwhile, the costs of the newer inventory are held on the balance sheet until they are sold.
Calculation and Example
To illustrate, consider a company with the following inventory purchases:
- 100 units @ $10 each = $1,000
- 100 units @ $12 each = $1,200
If the company sells 150 units, the cost of goods sold (COGS) would be calculated as follows under FIFO:
- First 100 units @ $10 = $1,000
- Next 50 units @ $12 = $600
- Total COGS = $1,600
The remaining inventory valuation would now be:
- 50 units @ $12 = $600
FIFO vs. LIFO
FIFO is often contrasted with LIFO (Last In, First Out), where the newest inventory costs are expensed first. While FIFO can result in lower COGS and higher net income in periods of rising prices, LIFO results in higher COGS and lower net income, which can be advantageous for tax purposes.
Historical Context and Applicability
FIFO has been a widely accepted method for inventory valuation for decades. It’s particularly useful in industries where inventory has a limited shelf life or obsolescence risk, such as the food and pharmaceutical industries. FIFO is also mandated by International Financial Reporting Standards (IFRS) and is widely used globally.
Special Considerations
Using FIFO can result in a higher taxable income compared with LIFO during periods of price inflation because older, cheaper costs are matched against current revenues. Companies must consider the impacts on financial performance and tax liabilities when choosing FIFO.
Related Terms
- LIFO (Last In, First Out): An inventory valuation method where the newest inventory costs are expensed first.
- Weighted Average Cost: A method that averages the cost of inventory throughout the period.
- Specific Identification: Assigns actual costs to the specific items sold.
- COGS (Cost of Goods Sold): The direct costs attributable to the production of the goods sold by a company.
FAQs
Can a company switch from FIFO to LIFO?
Why do companies prefer FIFO?
Is FIFO allowable under IFRS?
How does FIFO affect taxes?
References
- Mankiw, N. Gregory. Principles of Economics. Cengage Learning, 2020.
- “FIFO vs LIFO Accounting.” Investopedia. Accessed October 17, 2023.
In summary, FIFO (First In, First Out) is a robust and widely accepted inventory valuation method with significant implications for accounting, taxation, and financial reporting. It aligns closely with actual physical inventory flows and can provide a clearer picture of a company’s inventory and cost of goods sold.
