First In, First Out (FIFO)

What Is First In, First Out (FIFO)?

First In, First Out, commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first.

For tax purposes, FIFO assumes that assets with the oldest costs are included in the income statement's cost of goods sold (COGS). The remaining inventory assets are matched to the assets that are most recently purchased or produced.

Key Takeaways

  • First In, First Out (FIFO) is an accounting method in which assets purchased or acquired first are disposed of first.
  • FIFO assumes that the remaining inventory consists of items purchased last.
  • An alternative to FIFO, LIFO is an accounting method in which assets purchased or acquired last are disposed of first.
  • Often, in an inflationary market, lower, older costs are assigned to the cost of goods sold under the FIFO method, which results in a higher net income than if LIFO were used.
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First In, First Out (FIFO)

Understanding First In, First Out (FIFO)

The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense. Under FIFO, it is assumed that the cost of inventory purchased first will be recognized first. The dollar value of total inventory decreases in this process because inventory has been removed from the company’s ownership. The costs associated with the inventory may be calculated in several ways—one being the FIFO method.

Typical economic situations involve inflationary markets and rising prices. In this situation, if FIFO assigns the oldest costs to the cost of goods sold, these oldest costs will theoretically be priced lower than the most recent inventory purchased at current inflated prices. This lower expense results in higher net income. Also, because the newest inventory was purchased at generally higher prices, the ending inventory balance is inflated.

Example of FIFO

Inventory is assigned costs as items are prepared for sale. This may occur through the purchase of the inventory or production costs, through the purchase of materials, and utilization of labor. These assigned costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first.

Imagine if a company purchased 100 items for $10 each, then later purchased 100 more items for $15 each. Then, the company sold 60 items. Under the FIFO method, the cost of goods sold for each of the 60 items is $10/unit because the first goods purchased are the first goods sold. Of the 140 remaining items in inventory, the value of 40 items is $10/unit and the value of 100 items is $15/unit. This is because inventory is assigned the most recent cost under the FIFO method.

With this remaining inventory of 140 units, let's say the company sells an additional 50 items. The cost of goods sold for 40 of these items is $10, and the entire first order of 100 units has been fully sold. The other 10 units that are sold have a cost of $15 each, and the remaining 90 units in inventory are valued at $15 each (the most recent price paid).

The FIFO method follows the logic that to avoid obsolescence, a company would sell the oldest inventory items first and maintain the newest items in inventory. Although the actual inventory valuation method used does not need to follow the actual flow of inventory through a company, an entity must be able to support why it selected the use of a particular inventory valuation method.

FIFO vs. Other Valuation Methods

LIFO

The inventory valuation method opposite to FIFO is LIFO, where the last item purchased or acquired is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory when compared to FIFO.

Average Cost Inventory

The average cost inventory method assigns the same cost to each item. The average cost method is calculated by dividing the cost of goods in inventory by the total number of items available for sale. This results in net income and ending inventory balances between FIFO and LIFO.

Specific Inventory Tracing

Finally, specific inventory tracing is used when all components attributable to a finished product are known. If all pieces are not known, the use of any method out of FIFO, LIFO, or average cost is appropriate.

When Is First In, First Out (FIFO) Used?

The FIFO method is used for cost flow assumption purposes. In manufacturing, as items progress to later development stages and as finished inventory items are sold, the associated costs with that product must be recognized as an expense. Under FIFO, it is assumed that the cost of inventory purchased first will be recognized first which lowers the dollar value of total inventory.

What Are the Advantages of First In, First Out (FIFO)?

The obvious advantage of FIFO is that it's the most widely used method of valuing inventory globally. It is also the most accurate method of aligning the expected cost flow with the actual flow of goods which offers businesses a truer picture of inventory costs. Furthermore, it reduces the impact of inflation, assuming that the cost of purchasing newer inventory will be higher than the purchasing cost of older inventory. Finally, it reduces the obsolescence of inventory.

What Are the Other Inventory Valuation Methods?

The opposite of FIFO is LIFO (Last In, First Out), where the last item purchased or acquired is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory when compared to FIFO. Average cost inventory is another method that assigns the same cost to each item and results in net income and ending inventory balances between FIFO and LIFO. Finally, specific inventory tracing is used only when all components attributable to a finished product are known.

Article Sources
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  1. Internal Revenue Service. "Publication 538, Accounting Periods and Methods."

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