First In, First Out (FIFO) is an inventory valuation method used in accounting and financial management, where the cost of goods sold (COGS) is determined by the cost of the oldest inventory items. Under FIFO, the earliest acquired (or produced) goods are the first to be sold or used, with the result that ending inventory consists of the most recently purchased or produced goods.
How FIFO Works
Fundamental Principle
The core principle of FIFO is straightforward:
Steps in Implementing FIFO
- Record the cost of the initial inventory batch.
- As sales occur, assign the cost of goods sold based on the historical cost of the earliest inventory.
- Continue the process following the chronological acquisition of inventory until the oldest inventory is exhausted.
- Remaining inventory on hand is valued at the cost of the latest acquired goods.
Example
Assume a company purchases batches of widgets as follows:
- Batch 1: 100 units @ $10/unit
- Batch 2: 150 units @ $12/unit
- Batch 3: 200 units @ $14/unit
If the company sells 250 units, according to FIFO:
The remaining inventory would consist of:
Considerations
Inflationary Environment
In times of rapid inflation, FIFO tends to inflate profits. This is because the older, less expensive inventory is sold first, which reduces the COGS and consequently increases the gross profit. As a result:
Inventory Profits
The term “inventory profits” refers to the gains resulting from holding inventory that appreciates in cost due to inflation:
Applicability
Industries
FIFO is widely applicable across various industries, especially where inventory has a limited shelf life, such as in:
- Food and Beverage
- Pharmaceuticals
- Consumer Goods
Financial Statements
FIFO affects several sections of financial statements:
- Income Statement: Higher net income during inflationary periods.
- Balance Sheet: Inventory is valued closer to current market costs.
Comparisons
FIFO vs. LIFO (Last In, First Out)
- FIFO: Uses older costs, leading to higher net income and ending inventory during inflation.
- LIFO: Uses newer costs, resulting in lower net income and ending inventory during inflation.
FIFO vs. Weighted Average Cost
- Weighted Average Cost: Blends costs over the period, offering a middle-ground approach between FIFO and LIFO, leading to moderate net income and inventory values.
FIFO vs. Specific Identification
- Specific Identification: Matches costs to specific items, suitable for unique or high-value inventory.
Related Terms
- LIFO (Last In, First Out): An inventory valuation method where the most recently produced items are recorded as sold first.
- Weighted Average Cost: An inventory costing method that averages the cost of all goods available for sale during the period.
- COGS (Cost of Goods Sold): The direct costs attributable to the production of the goods sold by a company.
FAQ
Why is FIFO preferred in certain industries?
FIFO is preferred in industries where inventory has a short life cycle and is perishable, as it ensures that older inventory is used before it becomes obsolete.
What are the tax implications of using FIFO?
During inflationary periods, FIFO can lead to higher taxable income compared to LIFO, as it shows higher profits due to lower COGS.
Can a company switch from FIFO to LIFO?
Switching between FIFO and LIFO requires compliance with accounting standards and regulations, and typically must be justified as improving the accuracy of financial reporting.
References
- Financial Accounting Standards Board (FASB) guidelines.
- International Financial Reporting Standards (IFRS) on Inventory Valuation.
- Accounting textbooks and peer-reviewed journals on inventory management.
Summary
The First In, First Out (FIFO) method of inventory valuation is crucial for businesses needing to match sales with the oldest inventory costs, providing financial clarity and strategic advantages in certain economic environments. Understanding FIFO’s impacts, especially during inflation, equips managers with the insights necessary to accurately measure profitability and financial health.
By studying FIFO in depth, businesses and accounting professionals can ensure their inventory practices align with regulatory standards while maximizing financial outcomes.
