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. Show
Characteristics of FIFOA 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. Advantages of FIFOThe 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. Disadvantages of FIFOBecause 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 FIFOABC 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 MethodsAlternative 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. The sale or usage of goods follows the same order in which they are bought What is First-In First-Out (FIFO)?The First-in First-out (FIFO) method of inventory valuation is based on the assumption that the sale or usage of goods follows the same order in which they are bought. In other words, under the first-in, first-out method, the earliest purchased or produced goods are sold/removed and expensed first. Therefore, the most recent costs remain on the balance sheet, while the oldest costs are expensed first. FIFO is also called last-in-still-here (LISH).  Download the Free TemplateEnter your name and email in the form below and download the free template now! FIFO CalculatorDownload the free Excel template now to advance your finance knowledge! Example of First-In, First-Out (FIFO)Company A reported beginning inventories of 100 units at $2/unit. Also, the company made purchases of:
If the company sold 250 units, the order of cost expenses would be as follows: As illustrated above, the cost of goods sold (COGS) is determined with beginning inventories and moves its way downwards (to more recent purchases) until the required number of units sold is fulfilled. For the sale of 250 units:
The total cost of goods sold for the sale of 250 units would be $700. The remaining unsold 150 would remain on the balance sheet as inventory at the cost of $700.
FIFO vs. LIFOTo reiterate, FIFO expenses the oldest inventories first. In the following example, we will compare FIFO to LIFO (last in first out). LIFO expenses the most recent costs first. Consider the same example above. Recall that under First-In First-Out, the following cost flows for the sale of 250 units are given below: Compare this to the LIFO method of inventory valuation, which expenses the most recent inventories first: Under LIFO, the sale of 250 units:
The company would report a cost of goods sold of $1,050 and inventory of $350. Under FIFO:
Under LIFO:
Therefore, we can see that the balances for COGS and inventory depend on the inventory valuation method. For income tax purposes in Canada, companies are not permitted to use LIFO. However, US companies are able to use FIFO or LIFO. As we will discuss below, the FIFO method creates several implications on a company’s financial statements. Impact of FIFO Inventory Valuation Method on Financial StatementsRecall the comparison example of First-In First-Out and LIFO. The two methods yield different inventory and COGS. Now it is important to consider the impact of using FIFO on a company’s financial statements? 1. Better valuation of inventoryBy using FIFO, the balance sheet shows a better approximation of the market value of inventory. The latest costs for manufacturing or acquiring the inventory are reflected in inventory, and therefore, the balance sheet reflects the approximate current market value. For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. The company purchases another snowmobile for a price of $75,000. For the sale of one snowmobile, the company will expense the cost of the older snowmobile – $50,000. Therefore, it will provide higher-quality information on the balance sheet compared to other inventory valuation methods. The cost of the newer snowmobile shows a better approximation to the current market value. 2. Poor matching of revenue with expenseSince First-In First-Out expenses the oldest costs (from the beginning of inventory), there is poor matching on the income statement. The revenue from the sale of inventory is matched with an outdated cost. For example, consider the same example above with two snowmobiles at a unit cost of $50,000 and a new purchase for a snowmobile for $75,000. The sale of one snowmobile would result in the expense of $50,000 (FIFO method). Therefore, it results in poor matching on the income statement as the revenue generated from the sale is matched with an older, outdated cost. Key Takeaways from First-in First-Out (FIFO)
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How does FIFO affect cost of goods sold?(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost.
Why does FIFO have lower COGS?FIFO results in a lower cost of goods sold number. This is because older items generally tend to carry a lower cost than items purchased more recently, due to potential price increases. This will result in a higher profit.
How does LIFO and FIFO affect cost of goods sold?The main difference between LIFO and FIFO is based on the assertion that the most recent inventory purchased is usually the most expensive. If that assertion is accurate, using LIFO will result in a higher cost of goods sold and less profit, which also directly affects the amount of taxes you'll have to pay.
Does LIFO increase cost of goods sold?Under LIFO, each item you sell will increase your Cost of Goods Sold (COGS) by the value of the most recent inventory you purchased. The value of your ending inventory is then calculated based on your oldest inventory.
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