What is FIFO?
/FIFO is an acronym for first in, first out. It is a cost layering concept under which the first goods purchased are assumed to be the first goods sold. The concept is used to devise the valuation of ending inventory, which in turn is used to calculate the cost of goods sold. The FIFO concept is best shown with the following example.
Characteristics of FIFO
A company that uses FIFO will find that the costs it maintains in its records for its inventory will always be the most current costs, since the last items purchased are still assumed to be in stock. Conversely, the cost of the oldest items will be charged to the cost of goods sold. In a normal inflationary environment, this means that the cost of goods sold will be relatively low in comparison to current costs, which will increase the amount of taxable income; also, the inventory value reported on the balance sheet will approximately match current costs.
The FIFO concept also applies to the actual usage of inventory. When inventory items have a relatively short life span, it can be of considerable importance to structure the warehousing storage system so that the oldest items are presented to pickers first. Doing so reduces the risk of inventory spoilage.
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Advantages of FIFO
There are several advantages to using FIFO, which are as follows:
Layer usage. The key advantage of FIFO is that the oldest layers are used first; this means that the number of cost layers in the database is kept at a relatively low level through the ongoing usage of inventory items.
Reflects reality. The FIFO methodology generally matches how inventory items are used. It is quite logical to use your oldest units first, before they become obsolete or damaged.
Usable in all accounting frameworks. The FIFO method is allowed under both Generally Accepted Accounting Standards and International Financial Reporting Standards.
Disadvantages of FIFO
Because the oldest costs are charged to expense first, FIFO tends to result in the lowest possible reported cost of goods sold, which increases profits and therefore income taxes. Also, it does require the maintenance of some cost layers, which will need to be documented for the year-end audit.
Example of FIFO
ABC Company buys ten green widgets for $5 each in January, and an additional ten green widgets in February for $7 each. In March, it sells ten widgets. Based on the FIFO concept, the first ten units that ABC purchased should be charged to the cost of goods sold, on the theory that the first units into inventory should be the first ones removed from it. Thus, the cost of goods sold in March should be $50, while the value of the inventory at the end of March should be $70. Even if some of the actual $7 green widgets were sold in March, the FIFO concept states that the cost of the earliest units should still be charged to the cost of goods sold first.
Alternative Inventory Costing Methods
Alternative methods of accounting for inventory are the weighted average method, the last-in first-out method, and the specific identification method. The weighted average method is useful for avoiding cost layering. The last-in, first-out method is useful for reducing reported profit levels in an inflationary environment, while the specific identification method is used to track unique inventory items.