First in First Out (FIFO)

Under First in First Out (FIFO), the most recently purchased inventory items are included in ending inventory on the balance sheet. The assumption is that the oldest item in inventory is always the item sold, whether or not that is actually what happens. In addition, it is assumed the most recently purchased items are still in inventory at the end of the period.

An example of the FIFO method is a fruit stand. When someone buys an apple, the seller will try to sell the oldest apple first because if it spoils before its sale it will become “obsolete,” creating a loss for the fruit stand.

However, unless inventory is highly perishable as apples are, it does not matter whether or not the actual earliest item stocked is the item sold. Whether it is or not, the assumption is made that the earliest item stocked is the item sold each time a sale occurs.

In a period of rising costs, using FIFO will result in a higher ending inventory balance and a lower COGS (and therefore higher operating income) when compared to LIFO, which will be covered next. This occurs because the newest, highest-cost units of each inventory item are still on hand at year-end (higher ending inventory) and the oldest, lowest-cost units of each inventory item were sold during the year (lower cost of goods sold).

Under FIFO, ending inventory is essentially valued at current cost (or replacement cost), and cost of goods sold is reported at an older, historical cost. Therefore, the balance sheet has “current” figures because the inventory is valued at the more current costs.

Benefits of FIFO

• In a period of rising prices, cost of goods sold will be lower with FIFO than with other cost flow assumptions because the oldest, lowest-cost inventory will be assumed sold for each sale. Consequently, reported net income will be higher than it would be with other cost flow assumptions, which may be of benefit to some companies.
• When FIFO is used, inventory on hand will reflect more-current market prices than would be the case under other cost flow assumptions because the inventory on the balance sheet will be reported at the cost of the most recently purchased items.
• In the U.S., FIFO is the only inventory cost flow assumption that is not restricted in its usage for income tax purposes by the IRS.

Limitations of FIFO

• Although reported net income is higher under FIFO than under other cost flow assumptions, net cash flow will probably be lower. In a period of rising prices, taxable income will be higher, and higher taxable income means higher income taxes paid, which decreases net cash flow.
• Use of FIFO when prices are rising creates short-term, overstated operating income that is not sustainable due to lower-cost units purchased long ago being the ones expensed as cost of goods sold

FIFO in the Periodic System

At the end of the period, the company determines the total number of units of inventory it had available for sale during the period (beginning inventory plus inventory purchased during the period) and the cost of each of the units in beginning inventory and those purchased during the period. The cost of the units sold is the cost of the units in beginning inventory and, if sales exceeded the units in beginning inventory, the cost of the earliest units purchased during the period up to the total number of units sold. Ending inventory consists of the most recently purchased units or those purchased toward the end of the period that had not been sold before the end of the period. The value of the ending inventory is determined only at the end of the period.

FIFO in the Perpetual System

Under FIFO, the periodic and the perpetual methods result in the same numbers because according to FIFO the oldest unit is sold first.

Remember that under FIFO, the FIFO periodic and the FIFO perpetual methods produce the same result.