FIFO (First-In, First-Out) is one of the most widely used inventory valuation methods in accounting. It assumes that the oldest inventory items purchased or produced are sold first, and the remaining inventory consists of the most recently acquired items. FIFO is commonly used because it closely matches the actual physical flow of goods in many businesses, especially those dealing with perishable or time-sensitive products.
1. What is FIFO?
FIFO (First-In, First-Out) is an inventory costing method that assumes the first items added to inventory are the first ones to be sold. The cost of goods sold (COGS) is based on the cost of the earliest purchased inventory, while the ending inventory reflects the cost of the most recent purchases.
Key Characteristics of FIFO:
- Oldest Costs to COGS: The cost of the oldest inventory is assigned to the cost of goods sold.
- Recent Costs in Ending Inventory: The most recent inventory costs remain in the ending inventory on the balance sheet.
- Alignment with Physical Flow: Often matches the actual flow of goods, especially for perishable items.
- Impact on Financials: In times of rising prices, FIFO results in lower COGS and higher net income compared to other methods like LIFO.
2. How FIFO Works
The FIFO method operates under the assumption that goods are sold in the order they are purchased. This process affects both the cost of goods sold and the valuation of ending inventory.
Steps in Applying FIFO:
- Record Purchases: Track the cost and quantity of each purchase in chronological order.
- Assign COGS: When goods are sold, assign the cost of the oldest inventory to the cost of goods sold.
- Update Inventory: After each sale, adjust the inventory records to reflect the remaining items.
- Value Ending Inventory: The remaining inventory consists of the most recent purchases, valued at their respective costs.
3. Advantages of FIFO
FIFO offers several benefits that make it a popular choice for businesses and accountants.
A. Simplicity and Accuracy
- Easy to Understand: FIFO is straightforward and intuitive, making it easy to apply and explain.
- Accurate Inventory Valuation: Ending inventory reflects the most recent costs, providing a realistic valuation on the balance sheet.
B. Higher Profits in Inflationary Periods
- Lower COGS: Since older, cheaper inventory is sold first, the cost of goods sold is lower during periods of rising prices.
- Higher Net Income: Lower COGS leads to higher gross profit and net income, which can improve financial ratios and attract investors.
C. Better Matching of Physical Flow
- Reflects Actual Movement: FIFO often mirrors the actual flow of goods, especially for businesses handling perishable or time-sensitive items.
D. Compliance with Accounting Standards
- Accepted Internationally: FIFO is allowed under both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).
4. Disadvantages of FIFO
Despite its advantages, FIFO also has some limitations that businesses should consider.
A. Higher Tax Liabilities in Inflationary Periods
- Increased Taxes: Higher net income leads to higher taxable income, resulting in increased tax liabilities.
B. Potential Overstatement of Profits
- Inflated Profits: In times of rising prices, profits may be overstated, which may not reflect the actual economic situation.
C. Less Matching of Current Costs with Revenues
- Outdated Cost Matching: FIFO matches older costs with current revenues, which may not provide the most accurate picture of profitability.
5. Practical Examples of FIFO
Example 1: Simple FIFO Calculation
Scenario: A company makes the following purchases and sales:
- January 1: Purchased 100 units at $10 each.
- January 10: Purchased 50 units at $12 each.
- January 20: Sold 120 units.
Step 1: Calculate Cost of Goods Sold (COGS)
According to FIFO, the first 100 units sold come from the January 1 purchase, and the next 20 units come from the January 10 purchase.
- 100 units × $10 = $1,000
- 20 units × $12 = $240
Total COGS = $1,000 + $240 = $1,240
Step 2: Calculate Ending Inventory
After selling 120 units, 30 units remain from the January 10 purchase.
- 30 units × $12 = $360
Ending Inventory = $360
Example 2: FIFO in an Inflationary Period
Scenario: A company makes the following purchases and sales during a period of rising prices:
- March 1: Purchased 200 units at $15 each.
- March 15: Purchased 150 units at $18 each.
- March 25: Sold 250 units.
Step 1: Calculate Cost of Goods Sold (COGS)
The first 200 units sold come from the March 1 purchase, and the remaining 50 units come from the March 15 purchase.
- 200 units × $15 = $3,000
- 50 units × $18 = $900
Total COGS = $3,000 + $900 = $3,900
Step 2: Calculate Ending Inventory
After selling 250 units, 100 units remain from the March 15 purchase.
- 100 units × $18 = $1,800
Ending Inventory = $1,800
6. Accounting Entries Using FIFO
When using FIFO, the accounting entries for purchases and sales reflect the oldest inventory costs in the cost of goods sold.
A. Recording Purchases
Scenario: A company purchases 100 units at $10 each on January 1.
Journal Entry:
| Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|
| Inventory (Stock) A/c | $1,000 | |
| Accounts Payable A/c | $1,000 |
B. Recording Sales Using FIFO
Scenario: The company sells 80 units at $20 each on January 15.
Entry 1: Record the Sale
| Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|
| Accounts Receivable A/c | $1,600 | |
| Sales Revenue A/c | $1,600 |
Entry 2: Record the Cost of Goods Sold (COGS)
Using FIFO, the 80 units sold are from the January 1 purchase at $10 each.
| Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|
| Cost of Goods Sold (COGS) A/c | $800 | |
| Inventory (Stock) A/c | $800 |
7. FIFO vs. Other Inventory Valuation Methods
A. FIFO vs. LIFO
- FIFO: Results in lower COGS and higher profits during inflation.
- LIFO: Results in higher COGS and lower profits during inflation, reducing tax liabilities.
B. FIFO vs. Weighted Average Cost
- FIFO: Uses actual costs of specific batches of inventory.
- Weighted Average: Averages all inventory costs, providing a middle-ground valuation.
The Benefits of Using FIFO
FIFO (First-In, First-Out) is a simple, intuitive, and widely accepted inventory valuation method. It aligns with the actual flow of goods in many businesses and provides accurate, up-to-date inventory valuations. While it can result in higher profits and taxes during inflationary periods, FIFO offers transparency and compliance with accounting standards. Businesses should consider their financial goals, tax implications, and inventory management practices when choosing the FIFO method.