What is First in First Out (FIFO)? Definition, Pros and Cons

The first in, first out, aka FIFO accounting method assumes that sellable assets, such as inventory, raw materials, or components acquired first were sold first. The FIFO method of inventory valuation is a cost flow assumption that the first goods purchased are also the first goods sold. That is, the oldest merchandise is sold first, with its associated costs being used to determine profitability. (In contrast, LIFO – last in, first out – assumes the newest inventory is the first to sell.)

In reality, sales patterns don’t usually follow this simple assumption. You’ll often sell a mix of new and older merchandise.

But FIFO has to do with how the cost of that merchandise is calculated, with the older costs being applied before the newer. This is often different due to inflation, which causes more recent inventory typically to cost more than older inventory.

As a result, profits may be higher with FIFO than with LIFO. 

The FIFO method is allowed under both Generally Accepted Accounting Principles and International Financial Reporting Standards.

How Do You Calculate FIFO?

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.

The “inventory sold” refers to the cost of purchased goods (with the intention of reselling), or the cost of produced goods (which includes labor, material & manufacturing overhead costs).

Keep in mind that the prices paid by a company for its inventory often fluctuate. These fluctuating costs must be taken into account.

For instance, if a business sold 200 units of an item, and 150 units were originally purchased by the company at $10.00 and 50 units were purchased at $15.00, it cannot assign the $10.00 cost price to every unit sold. Only 150 units can be. The remaining 50 items must be assigned to the higher price, the $15.00.

Lastly, the product needs to have been sold to be used in the equation. You cannot apply unsold inventory to the cost of goods calculation.

What Are the Advantages of FIFO?

The FIFO method is considered to me a more trusted method than the LIFO (“Last-In, First-Out”) method. 

The advantages to the FIFO method are as follows:

  • The method is easy to understand, universally accepted and trusted.
  • FIFO follows the natural flow of inventory (oldest products are sold first, with accounting going by those costs first). This makes bookkeeping easier with less chance of mistakes.
  • Less waste (a company truly following the FIFO method will always be moving out the oldest inventory first).
  • Remaining products in inventory will be a better reflection of market value (this is because products not sold have been built more recently).
  • Higher profit.
  • Financial statements are harder to manipulate.

The FIFO method gives a very accurate picture of a company’s finances. 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. This information helps a company plan for its future.

What Are the Disadvantages of FIFO?

The FIFO method can result in higher income tax for a business to pay, because the gap between costs and profit is wider (than with LIFO).

A company also needs to be careful with the FIFO method in that it is not overstating profit. This can happen when product costs rise and those later numbers are used in the cost of goods calculation, instead of the actual costs.

What Type of Business FIFO Is Best For?

  • Businesses with a periodic inventory system: With a periodic inventory system, the quantity of inventory is determined at the end of each period with a physical count. With FIFO, costs can be assigned to the inventory easily by looking at the most recent purchases.
  • Businesses that sell perishable items and sell the oldest items first: While the actual flow of goods isn’t required to match your FIFO assumption, FIFO will give you the most accurate calculation of your cost of inventory and sales profit if your goods do follow a FIFO flow. This includes businesses that sell food or other products with an expiration date, like medication.
  • Companies that do business internationally: FIFO is one of the few inventory valuation methods allowed under international financial accounting standards (IFRS). Another popular method, last-in, first-out (LIFO), isn’t allowed.

What Type of Business FIFO Is Not Right For?

  • Businesses with highly fluctuating prices: Because pricing isn’t always consistent, these types of businesses might prefer the average cost method to smooth out costs.
  • Businesses that use LIFO on their tax return: Some businesses choose last-in, first-out (LIFO) inventory accounting for tax purposes, as it usually results in lower taxable income if the price of inventory is increasing over time. If you choose LIFO for tax purposes, the IRS requires you to also use it for your books.
  • Businesses selling high-value items: Companies like car and equipment dealers that sell high-dollar items should generally use specific identification to keep track of each inventory item’s actual cost. This is usually pretty straightforward, as high-dollar items tend not to be identical to each other and can be distinguished by serial numbers.

What about LIFO?

Last-in, first-out (LIFO) is another technique used to value inventory, but it’s not one commonly practiced, especially in restaurants.

Last-in, first-out values inventory on the assumption that the goods purchased last are sold first at their original cost. In this scenario, the oldest goods usually remain as ending inventory. Under the LIFO system, many food items and goods would expire before being used, so this method is typically practiced with non-perishable commodities.

When the price of goods increases, those newer and more expensive goods are used first according to the LIFO method. This increases the overall cost of goods sold and leaves the cheaper, earlier purchased goods as inventory, which may end up not even being sold under the LIFO model.

Bottom Line

While it’s useful to have a basic understanding of how to use the FIFO inventory method, we strongly recommend using accounting software, or partnering with a third-party logistics provider (3PL) to handle your inventory management. They will handle all of the tedious calculations for you in the background automatically in real-time. This will ensure that your balance sheet will always be up to date with the current cost of your inventory, and your profit and loss (P&L) statement will reflect the most recent COGS and profit numbers.

 

Help with inventory management is one of the many benefits to working with a 3PL. If you are seeking logistics support we’d love to hear from you. You can read DCL’s list of services to learn more, or check out the many companies we work with to ensure great logistics support. Send us a note to connect about how we can help your company grow.