First in, first out method (FIFO) definition
/What is the First-in, First-out Method?
The first in, first out (FIFO) method of inventory valuation is a cost flow assumption that the first goods purchased are also the first goods sold. In most companies, this assumption closely matches the actual flow of goods, and so is considered the most theoretically correct inventory valuation method. The FIFO flow concept is a logical one for a business to follow, since selling off the oldest goods first reduces the risk of inventory obsolescence.
Understanding the First-in, First-out Method
Under the FIFO method, the earliest goods purchased are the first ones removed from the inventory account. This results in the remaining items in inventory being accounted for at the most recently incurred costs, so that the inventory asset recorded on the balance sheet contains costs quite close to the most recent costs that could be obtained in the marketplace. Conversely, this method also results in older historical costs being matched against current revenues and recorded in the cost of goods sold; this means that the gross margin does not necessarily reflect a proper matching of revenues and costs. For example, in an inflationary environment, current-cost revenue dollars will be matched against older and lower-cost inventory items, which yields the highest possible gross margin.
The FIFO method is allowed under both Generally Accepted Accounting Principles and International Financial Reporting Standards. The FIFO method provides the same results under either the periodic or perpetual inventory system.
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Example of the First-in, First-out Method
Milagro Corporation decides to use the FIFO method for the month of January. During that month, it records the following transactions:
| Quantity Change |
Actual Unit Cost |
Actual Total Cost |
|
| +100 | $210 | $21,000 | |
| Sale | -75 | ||
| Purchase (layer 2) | +150 | 280 | 42,000 |
| Sale | -100 | ||
| Purchase (layer 3) | +50 | 300 | 15,000 |
| Ending inventory | = 125 |
The cost of goods sold in units is calculated as:
100 Beginning inventory + 200 Purchased – 125 Ending inventory = 175 Units
Milagro’s controller uses the information in the preceding table to calculate the cost of goods sold for January, as well as the cost of the inventory balance as of the end of January.
| Units | Unit Cost | Total Cost | |
| Cost of goods sold | |||
| FIFO layer 1 | 100 | $210 | $21,000 |
| FIFO layer 2 | 75 | 280 | 21,000 |
| 175 | $42,000 | ||
| Ending inventory | |||
| FIFO layer 2 | 75 | 280 | $21,000 |
| FIFO layer 3 | 50 | 300 | 15,000 |
| 125 | $36,000 |
Thus, the first FIFO layer, which was the beginning inventory layer, is completely used up during the month, as well as half of Layer 2, leaving half of Layer 2 and all of Layer 3 to be the sole components of the ending inventory.
Note that the $42,000 cost of goods sold and $36,000 ending inventory equals the $78,000 combined total of beginning inventory and purchases during the month.
Advantages of the FIFO Method
There are several advantages to using the FIFO method, which are noted below:
Reflects actual inventory flows. In most organizations, the oldest inventory items are sold or used first, since they are the most subject to obsolescence (especially for organizations that sell perishable goods). Consequently, the FIFO method most accurately reflects the actual flow of goods within a business.
Higher inventory valuation. The FIFO method removes the oldest items from stock first, which usually means that the lowest-cost items are removed from stock, leaving the more recent, higher-cost items in inventory. This results in a higher inventory valuation. This can be useful, if your lender is willing to loan your business more money based on a higher inventory valuation.
Higher reported income. The FIFO method charges lower-cost items to the cost of goods sold, which results in a higher reported earnings level. This can be good news for those investors who are seeking the highest possible return on their investment.
The Difference Between FIFO and LIFO
The reverse approach to inventory valuation is the LIFO method, where the items most recently added to inventory are assumed to have been used first. This approach is useful in an inflationary environment, where the most recently-purchased higher-cost items are removed from the cost layering first, while older, lower-cost items are retained in inventory. This means that the ending inventory balance tends to be lower, while the cost of goods sold is increased, resulting in lower taxable profits. The use of LIFO is banned under IFRS.