Understanding FIFO as an Inventory Costing Method

Understanding FIFO as an Inventory Costing Method

You should know that FIFO is an accepted inventory costing method in the U.S. under Generally Accepted Accounting Principles (GAAP). Let me explain what the FIFO method is. FIFO means 'First In, First Out.' It's a valuation approach where older inventory gets moved out before new inventory arrives. The first goods you sell are the first ones you purchased, so the newest items stay in your inventory.

Remember, the inventory valuation method your company chooses doesn't have to match the actual flow of inventory through your business, but you must justify why you selected it.

Key Takeaways on FIFO

Under FIFO, the cost of the inventory you purchased first gets recognized first. This contrasts with LIFO, where the last assets acquired are disposed of first. FIFO assumes that assets with the oldest costs go into the income statement's Cost of Goods Sold (COGS).

How the FIFO Method Works

The FIFO method serves cost flow assumption purposes. As items move through development stages and finished goods are sold, the costs must be expensed. With FIFO, the costs of the first inventory purchased are recognized first. This process decreases the dollar value of your total inventory as items leave your ownership. You can calculate inventory costs in various ways, and FIFO is one of them.

In typical inflationary markets with rising prices, the oldest costs under FIFO will be lower than recent purchases at inflated prices when assigned to COGS. This leads to lower expenses, higher net income, and an inflated ending inventory balance.

Companies pick their valuation method, and some choose one that mirrors their inventory flow. For instance, a grocer often sells the oldest inventory first.

A Practical Example of FIFO

Inventory gets assigned costs based on the order of use, and for FIFO, it's what arrived first. Suppose your company bought 100 items for $10 each, then 100 more for $15 each, and sold 60 items. Under FIFO, the COGS for those 60 is $10 per unit because the first purchases are sold first. Of the remaining 140 items, 40 are valued at $10/unit and 100 at $15/unit, reflecting the most recent costs.

If you then sell another 50 items, the COGS for 40 is $10, fully depleting the first order, and the next 10 are $15 each. The remaining 90 units in inventory are all valued at $15, the latest price paid.

Comparing FIFO to LIFO

LIFO is the opposite of FIFO; the last item purchased is the first out. In inflationary times, this deflates net income and lowers ending inventory compared to FIFO. Under LIFO, sold items get a higher COGS during price increases. On the balance sheet, FIFO keeps more expensive items as inventory, often leading to higher net income and larger inventory values. Note that LIFO isn't allowed under International Financial Reporting Standards.

Other Inventory Valuation Methods

Average cost inventory assigns the same cost to each item by dividing total inventory cost by the number of items available, resulting in net income and ending balances between FIFO and LIFO. Specific inventory tracing applies when all components of a product are known; otherwise, use FIFO, LIFO, or average cost.

Advantages and Disadvantages of FIFO

The FIFO method is straightforward to understand and apply. Your statements become more transparent, and it's harder to manipulate accounts for better financial appearances. FIFO is required under International Financial Reporting Standards and is standard in many places. It follows the natural inventory flow, as most businesses sell oldest products first, so accounts better reflect current inventory value with newer unsold items.

However, FIFO can lead to higher income taxes due to the gap between costs and revenue. In places allowing LIFO, companies might prefer listing recent costs first to match rising expenses and lower taxes. FIFO might overstate profits and not truly reflect inventory flow in innovative industries.

Why FIFO Is Popular

FIFO is the most used inventory valuation method worldwide. It accurately aligns expected cost flow with actual goods flow, giving you a true picture of costs. It minimizes inflation's impact, as newer inventory costs more than older purchases.

Other Inventory Valuation Methods Explained

LIFO, opposite of FIFO, sells the last acquired item first, leading to lower net income and inventory in inflation. Average cost assigns uniform costs, balancing between FIFO and LIFO. Specific tracing is for known components only.

How to Calculate FIFO

Calculate FIFO by adding costs of the earliest sold inventory items. For 10 sold units, sum the first 10 purchased; this is COGS, varying by method.

The Bottom Line on FIFO

The FIFO method assumes assets sell in purchase order. Some jurisdictions mandate it, but even where not, its ease and transparency make it popular.