What Is First-In First-Out (FIFO) Method? Definition and Example

What is FIFO?

FIFO stands for First-In, First-Out, where oldest inventory items are sold or used first, meaning that costs are assigned in the same order as those purchased or produced. 

FIFO method helps companies to align inventory flow with cost flow, aiding in accurate accounting and strategic decision-making.

FIFO is an approach to cost flow assumptions that assume that the first-bought or first-produced products will be sold first.

FIFO operates under the presumption that the first products added to inventory are also the first ones sold and are frequently employed by firms that maintain a physical inventory of some type. Items depart inventories in the same order they entered under FIFO.

When businesses sell older inventory at current, inflated market pricing, they can lessen the impact of inflation and assist the company in selling inventory before it becomes obsolete. Moreover, businesses that use it can also opt for tax minimization strategies.

Why is FIFO crucial to businesses?

FIFO is crucial to businesses for the following reasons:

• Accurate Cost Tracking: FIFO ensures that the cost of goods sold reflects the actual purchase price of older inventory, providing a more accurate picture of profit margins, especially during inflation or price fluctuations.

• Better Inventory Management: By moving older stock first, FIFO helps reduce the risk of stock obsolescence or spoilage, especially for perishable goods or products with expiration dates.

• Financial Reporting Compliance: FIFO often aligns with International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) and , improving the accuracy and transparency of financial statements.

• Tax Efficiency in Inflationary Times: In an inflationary environment, FIFO tends to report higher net income due to using older, cheaper inventory first, which can have tax implications.

• Simplified Accounting Process: FIFO provides a straightforward and logical method for tracking inventory and calculating costs, making it easier for businesses to maintain accurate records and perform audits.

• Improved Customer Satisfaction: FIFO can improve customer satisfaction by ensuring that products are fresher and less likely to be outdated, particularly in industries like food and pharmaceuticals.

Understanding FIFO method with an example

First In First Out Method Example

Happy Hour Supermarket purchased 100 cakes at $2 each on Monday. On Tuesday, Happy Hour Supermarket purchased 50 more cakes at $3 each as the price went up due to inflation. How will the store clear its stock and calculate the COGS using the FIFO method?

Total number of cakes in inventory = 150 

Total number of cakes sold = 110

Cost of Goods Sold (COGS) = Original units sold from the first batch (the initial purchase) x cost of each unit + Remaining units from the second batch x cost of each unit

Cost of Goods Sold (COGS) = ( 100 * 2 ) + ( 10*3) 

                                              =  230 

What is the Purpose of the FIFO Equation?

The FIFO approach is based on the idea that to prevent obsolescence; a business should sell its oldest inventory products first and keep its newest ones on hand. An entity must be able to explain why it chose to adopt a specific inventory valuation technique, even though the actual method utilized does not have to correspond to the real flow of inventory through a corporation.

The primary purpose of the FIFO equation is as follows: 

• Accurate Financial Reporting: It helps in calculating the cost of goods sold and ending inventory for financial statements, ensuring transparency and compliance with accounting standards.
• Profitability Analysis: By matching older costs with current revenues, FIFO helps businesses better understand their gross profit and margins, particularly when inventory costs are changing over time.
• Inventory Valuation: FIFO provides a clear method for valuing inventory, which is crucial for balance sheet accuracy and for assessing the overall financial health of the business.
• Tax Implications: Since FIFO results in higher net income during inflationary periods (as older, cheaper inventory is used first), it affects the taxable income and thus the taxes a business may owe.
• Operational Efficiency: It supports effective inventory management by ensuring older stock is used or sold first, reducing the risk of obsolescence or spoilage.

What are the pros and cons of FIFO?

Pros of FIFO

• Accurate Costing in Rising Price Environments: FIFO assigns the cost of the oldest, usually cheaper inventory to the cost of goods sold (COGS). This means that during periods of rising prices or inflation, the remaining inventory is valued at more recent (higher) prices, leading to higher asset values on the balance sheet.

• Simplicity and Logical Flow: FIFO is simple to understand and implement, aligning with natural business operations where the oldest items are typically sold or used first. This makes inventory tracking easier.

• Higher Net Income in Inflation: Since older, lower-cost inventory is sold first, the COGS is lower, resulting in a higher net income. This can be beneficial for businesses that want to showcase strong financial performance.

• Favorable for Financial Reporting: FIFO often provides a more accurate representation of current market conditions, as it ensures that the inventory on the balance sheet is valued closer to current prices, making financial reports more relevant and reflective of actual inventory costs.

• Improved Inventory Turnover: FIFO encourages the sale or usage of older inventory first, reducing the risk of inventory becoming obsolete, damaged, or perishable. It helps maintain fresher stock, which is especially important for industries like food and retail.

Cons of FIFO

• Higher Taxes in Inflationary Times: With FIFO, when net income is higher due to lower COGS (since cheaper inventory is sold first), it results in a higher taxable income. This can increase the tax liability, which may not be favorable for businesses seeking to minimize taxes.

• Complexity in Deflationary Periods: During deflation, FIFO can lead to a lower valuation of ending inventory, as the newer, lower-cost inventory is left unsold, while older, higher-cost inventory is reflected in COGS. This can result in overstated expenses and lower net income.

• Not Reflective of Economic Reality in Some Cases: FIFO does not always reflect the current economic situation, particularly when there are significant fluctuations in inventory costs. It may not accurately show the real cost businesses incur in the short term, leading to financial discrepancies.

• Mismatch with Replacement Costs: FIFO might not reflect the actual cost of replacing inventory, especially in times of inflation. Since the older, cheaper goods are sold first, the inventory that remains may be priced much higher, which could distort profit margins and future inventory replacement strategies.

• Lower COGS in Inflation: While lower COGS boosts profits, it may not accurately reflect the current cost of inventory. In times of inflation, the cost of replacing sold goods may be significantly higher than the costs recorded, potentially leading to cash flow issues when restocking.

Requirements for FIFO to be Applicable

FIFO is a method commonly used by businesses, particularly in retail, food, and related industries, to manage inventory. FIFO approach ensures that the oldest stock in inventory is sold first.

Under GAAP, businesses can choose from three inventory valuation methods: FIFO, average cost, and LIFO. However, under IFRS, businesses can only use the FIFO method. To implement the FIFO method effectively, several key requirements should be met:

1. Inventory Audits

Regular inventory audits are necessary to maintain FIFO accuracy. Audits help identify any discrepancies or issues with the method’s implementation and ensure that the oldest items are sold first, particularly during supply chain challenges.

2. Detailed Inventory Tracking

Accurate tracking of products as they enter and exit the inventory is essential for FIFO. Keeping precise records of inventory costs ensures that the first items brought into stock are the first to be sold.

3. Employee Training

Employees must understand the FIFO concept and its importance for maintaining a smooth flow of operations. Proper training ensures staff can accurately track inventory costs and appropriately label and organize products.

4. Proper Labeling and Inventory Management

Effective labeling and organization of inventory are critical for FIFO. Clear labeling helps identify the oldest items, ensuring they are sold first. Labels should include manufacturing or arrival dates, aiding in better inventory management.

How Does FIFO Work?

The core principle of the First-In, First-Out (FIFO) method is that the items added to inventory first are sold. Companies using FIFO ensure that their oldest stock is used or sold before newer inventory.

In times of inflation, production costs often rise over time. By selling the oldest inventory first, businesses using FIFO may benefit from higher profitability since the cost of goods sold (COGS) is based on lower, earlier costs.

FIFO is commonly employed by businesses that deal in short-lived or perishable goods, such as food, medicine, and similar consumer products.

To calculate COGS using the FIFO inventory method, businesses use the following formula:

COGS = (Units sold from the first batch × cost per unit) + (Remaining units from the second batch × cost per unit)

This calculation begins with the cost of older inventory and works forward to newer inventory.

FIFO vs. LIFO

The two most popular methods for determining the cost of products sold out, and inventories are LIFO and FIFO. First in, first out is abbreviated as FIFO, which denotes that the first items entered into inventory are often the first items removed from inventory for sale.

The name “last in, first out,” or LIFO, stands for this concept: the items that were most recently added to inventory are thought to be the items that are first removed from inventory for sale.

Why pick one method over another?

The following are some factors to consider:

	FIFO	LIFO
Abbreviation	It stands for first-in, first-out	It stands for last-in, first-out
Approach	The FIFO approach is the reverse since it utilizes lower cost figures when computing COGS and believes the oldest goods in your inventory will be sold first.	The LIFO approach is based on the belief that the newest items in your inventory will be consumed first.
Results	FIFO results in a larger closing inventory and lower COGS.	Most of the time, LIFO will cause a decrease in closing inventory and an increase in COGS.
Popularity among Industries	FIFO is more popular since it is a globally recognized accounting concept and because firms often seek to sell their oldest inventory before bringing in new stock.	Businesses with big inventories tend to choose LIFO because it allows them to benefit from larger cash flows and reduced taxes while prices rise.
Inflation	When expenses rise, the first products sold are the least costly; as a result, your cost of goods sold declines, you report higher profits, and you, therefore, pay more income taxes in the short run.	If expenses are rising, the final products sold will be the costliest; as a result, your cost of goods sold will increase, you’ll report fewer profits, and you’ll pay less in income taxes in the short run.

Which one is better – FIFO / LIFO

For individuals who wish to be as compliant with accounting and legal obligations as possible while yet enjoying better profits and net worth amid inflation, FIFO is the best option.

However, businesses that want to lower their tax obligations and do not prioritize either investing in new projects or acquiring credit at the best rates possible during inflationary times are attracted to LIFO.

While the Generally Accepted Accounting Principles (GAAP) in the United States enable businesses to choose between LIFO and FIFO accounting, the International Financial Reporting Standards (IFRS) only permit FIFO accounting.

The decision between FIFO and LIFO inventory accounting will ultimately depend on your company’s requirements and the region in which it is based.

How is FIFO better than LIFO?

Most businesses prefer FIFO to LIFO because there is hardly a good reason to use recent inventory first while letting older stock deteriorate. This is especially true if you sell perishable goods or products depreciating fast.

Moreover, results produced through FIFO are more likely to be precise. This is due to the simpler nature of calculating profit from stock, which makes it simple to update your financial accounts and save time and money. Additionally, it prevents outdated stock from being re-counted or sitting around for so long that it loses its usability resulting in lost revenue and wastage of commodities.

Conclusion

Any firm that wants to grow must have excellent bookkeeping practices. Accounting offers us a variety of approaches, but FIFO stands out for its ease of use and viability. Due to its effectiveness in boosting earnings many companies worldwide use FIFO.

FAQs

What are the five main reasons for using FIFO?

Five advantages of FIFO storage:

• Increased Warehouse Area.
• There is more efficiency in warehouse operations.
• Minimizes stock handling as possible.
• Improved Quality Assurance.
• Control over warranties.

Why should businesses adopt first in, first out (FIFO) principles?

Reducing the effect of inflation on your inventory expenses is one of the main benefits of employing the first in, first out approach. Inventory profit is maximized by selling older stock created when inflation and costs are lower.

How does FIFO impact ending inventory?

Due to the fact that the older things have been used up and the most recent purchases match current market pricing, FIFO can be a better estimate of the value for ending inventory.

Which technique of inventory valuation is the best?

Most organizations employ the FIFO technique in inventory accounting since it often provides the most accurate representation of costs and profitability.

Under which method of inventory cost flows is the cost flow assumed to be in the reverse order in which the expenditures were made?

The Last-In, First-Out (LIFO) method assumes that the cost flow of inventory is in the reverse order in which the expenditures were made. Under LIFO, the most recent items purchased or produced (the “last in”) are the first ones to be sold or used (the “first out”). This means that older inventory costs remain on the balance sheet.

Which technique of inventory is the best under inflation?

FIFO: FIFO can potentially increase the value of remaining inventory and result in higher net income during inflation.

What is the primary reason for the popularity of LIFO?

The Last-In, First-Out (LIFO) method is popular because it offers potential tax benefits. When prices are rising, LIFO allows businesses to match their most recent, higher-cost inventory against current revenues. This results in higher costs for goods sold (COGS), lower taxable income, and consequently, lower taxes.

Why do most businesses employ FIFO?

Since FIFO tracks inventory in line with the natural flow of inventory, older products will be sold first. By doing this, the possibility of having unsalable, out-of-date products on the books is eliminated.