First In, First Out (FIFO)

What is FIFO?

First In, First Out (FIFO) is an inventory valuation method that assumes the oldest inventory items are sold first. Under FIFO, costs of the earliest purchases are recognized in Cost of Goods Sold (COGS) when sales occur, and the most recent purchases remain in ending inventory. A company’s chosen valuation method does not have to match the physical flow of goods, but it must be consistently applied and justified.

How FIFO works

FIFO is a cost-flow assumption used to allocate costs between COGS and ending inventory. Key effects:

• In an inflationary environment (rising prices), FIFO assigns lower historical costs to COGS, which typically raises reported gross profit and net income.
• Ending inventory values reflect the most recent (usually higher) purchase costs, so inventory on the balance sheet is higher under FIFO than under methods that charge recent costs to COGS.
• In deflationary periods, the opposite occurs: FIFO can reduce reported profit because earlier (higher) costs flow through COGS first.

Example

A company purchases:
* 100 units at $10 each
* 100 units at $15 each

Scenario 1 — Sell 60 units:
* Under FIFO, the 60 units sold are from the first lot: COGS = 60 × $10 = $600.
* Remaining inventory: 40 units @ $10, 100 units @ $15.

Scenario 2 — Then sell 50 more units:
* The next 40 units come from the remaining $10 units (40 × $10 = $400).
* The remaining 10 units sold come from the $15 lot (10 × $15 = $150).
* COGS for this sale = $400 + $150 = $550.
* Remaining inventory after both sales: 90 units @ $15 = $1,350.

FIFO vs. LIFO

• FIFO (First In, First Out): Oldest costs flow to COGS first. Typically results in higher net income and higher ending inventory during inflation.
• LIFO (Last In, First Out): Most recent costs flow to COGS first. Often reduces taxable income in inflationary periods by matching higher recent costs against revenue. LIFO is not permitted under IFRS.

Choosing between them affects reported profit, taxes, and balance-sheet inventory values.

Other valuation methods

• Average Cost (Weighted Average): Allocates a uniform cost per unit by dividing total cost of goods available for sale by total units available. Results usually fall between FIFO and LIFO values.
• Specific Identification: Tracks the actual cost of each specific item sold (used when items are distinct and easily tracked, e.g., unique assets).

Advantages and disadvantages

Pros
* Simple to understand and apply.
* Often mirrors the physical flow of goods (perishable or dated items).
* Produces ending inventory values that reflect recent purchase prices.
* Required or preferred under many accounting regimes (including IFRS).

Cons
* In inflationary periods, can overstate profits and increase income taxes.
* May not reflect actual physical flow for some industries (e.g., manufacturing with interchangeable components).
* Can give a less conservative measure of profitability compared with LIFO when prices are rising.

How to calculate FIFO

1. List inventory purchases chronologically with unit costs.
2. When a sale occurs, allocate units sold to the earliest remaining purchases.
3. Sum the costs of those allocated units to compute COGS.
4. Remaining unsold units are valued at the most recent purchase costs to determine ending inventory.

When to use FIFO

Use FIFO when you want inventory on the balance sheet to reflect current costs, when physical inventory is rotated (freshness matters), or when compliance with accounting standards (e.g., IFRS) requires it. It’s also common for businesses that prefer clearer, less manipulable financial reporting.

Bottom line

FIFO is a straightforward, widely used inventory valuation method that assigns the oldest costs to COGS and the newest costs to ending inventory. Its choice affects reported profit, tax liability, and balance-sheet values, so companies should select the method that best reflects their economic circumstances and regulatory requirements.