FIFO (First-In, First-Out)
In accounting, various methods are employed to calculate the value of inventory and track the cost of goods sold.
The first-in, first-out (FIFO) method is an inventory valuation method that assumes the first items purchased are the first items sold.
In other words, it assumes that the oldest inventory is sold before the newer inventory.
When determining the cost of goods sold and the value of ending inventory, FIFO assigns the cost of the oldest items in stock to sales and leaves the cost of newer purchases in the inventory.
This method is commonly used by companies that sell perishable goods or those that have a high turnover rate of inventory, such as grocery stores and restaurants.
Proper use of the FIFO method can help businesses optimize their inventory management, improve profitability, and make informed decisions about future purchasing decisions.
How the FIFO Method Works
The FIFO method assumes that the first goods purchased are sold first. As a result, the cost of goods sold (COGS) is based on the cost of the oldest inventory, while the ending inventory value is based on the cost of the newest inventory.
Under FIFO, the assumption is that older inventory costs have been expensed, and the remaining inventory is valued at newer, higher costs.
Example of Calculating Inventory Using FIFO
Let’s take the example of a retail store that sells socks.
The store purchases 50 socks for $5 each on January 1st and then purchases 100 more for $6 each on February 1st. The store then sells 70 socks in March.
Using the FIFO method, the cost of goods sold would be calculated as follows:
- We assume that the first 50 socks purchased in January were sold first, and therefore the cost of goods sold would be (50 socks x $5) = $250.
- The remaining 20 socks sold in March came from the February 1st purchase, which cost $6 each. Therefore, the cost of goods sold for these 20 socks would be (20 socks x $6) = $120.
The ending inventory value would be the remaining 60 socks from the February 1st purchase, which were valued at $6 each. Therefore, the ending inventory value would be (60 socks x $6) = $360.
FIFO vs LIFO: What Is the Difference?
FIFO and LIFO are both inventory valuation methods, but the main difference between them is the order in which the goods are sold.
While the FIFO method assumes that the oldest inventory is sold first, the last-in, first-out (LIFO) method assumes that the newest inventory is sold first.
The choice between using FIFO or LIFO can have a significant impact on a company’s financial statements.
For example, if the cost of goods sold is based on older, lower prices (FIFO), the company’s net income will be higher, and its taxes will be lower.
Conversely, if the cost of goods sold is based on newer, higher prices (LIFO), the company’s net income will be lower, and its taxes will be higher.