First In, First Out (FIFO) is a method used in accounting and inventory management to value and manage assets. According to this principle, assets that are acquired or produced first are sold, used, or disposed of before those acquired or produced later. It ensures that the oldest inventory items are recorded as sold first, potentially reducing the impact of inventory obsolescence.
How FIFO Works
FIFO implies that the cost of goods sold (COGS) is based on the cost of the earliest purchased inventory items. The remaining inventory, thus, consists of the most recently acquired products.
This method contrasts with other inventory valuation methods like Last In, First Out (LIFO) and Weighted Average Cost.
Types of FIFO
Pure FIFO
In pure FIFO, the first batch of goods or materials received is always the first one to be used or sold, maintaining a strict chronological order.
Modified FIFO
In some cases, especially in periodic inventory systems, a modified version of FIFO might be used where goods are grouped and the first group to be used is the oldest based on the time it was added to inventory.
Special Considerations
Inflation and Price Fluctuations
FIFO often results in higher taxable income during periods of inflation, as the older, cheaper costs of goods sold increase the gross profit, assuming newer, more expensive inventory remains. This can impact a company’s tax liability and financial reporting.
Applicability to Different Industries
FIFO is particularly beneficial for perishable goods industries, like food and pharmaceuticals, where using the oldest stock first is crucial to minimize waste and ensure product quality.
Examples of FIFO
Example in Retail
A grocery store that sells milk might use the FIFO method to ensure that the oldest stock is sold first to prevent spoilage. If the store acquires milk deliveries at different costs:
- 100 units at $2/unit on Day 1
- 100 units at $3/unit on Day 2
If 150 units are sold, under FIFO, the COGS calculation would take 100 units at $2 and 50 units at $3.
Example in Manufacturing
A car manufacturer may use FIFO to track the costs of raw materials like steel. If the manufacturer purchases steel in batches:
- 10,000 tons at $500/ton in January
- 10,000 tons at $550/ton in February
FIFO will allocate the cost of steel used based on the sequence of purchases, starting with the January stock.
Historical Context
The FIFO method is long-established in accounting principles and was standardized as part of Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Comparisons with Other Methods
FIFO vs. LIFO
FIFO results in higher ending inventory values and lower cost of goods sold during periods of rising prices, while LIFO does the opposite.
FIFO vs. Weighted Average
Weighted Average smooths out price fluctuations by taking an average cost for inventory valuation, unlike FIFO, which values based on specific acquisition costs.
Related Terms
- LIFO (Last In, First Out): An inventory valuation method where the newest items are sold first.
- Weighted Average Cost: An inventory valuation method calculating the cost of inventory and COGS based on the average cost of all goods.
Frequently Asked Questions
Does FIFO comply with international accounting standards?
Yes, FIFO is accepted worldwide and complies with both GAAP and IFRS.
How does FIFO affect financial statements during inflation?
FIFO usually results in higher net income and inventory valuation on the balance sheet, as the COGS reflect older, cheaper costs compared to the current market prices.
References
- American Institute of Certified Public Accountants (AICPA), “Generally Accepted Accounting Principles (GAAP)”
- International Financial Reporting Standards (IFRS)
- Accounting textbooks and manuals.
Summary
The FIFO method is a fundamental inventory valuation and accounting practice widely used across various industries. By ensuring that the oldest inventory is used first, FIFO helps in accurate financial reporting and management of inventory costs, especially in contexts with price volatility. Understanding how and when to apply FIFO can significantly influence a company’s financial decisions and overall profitability.
