First in first out (F.I.F.O.)

3 key takeaways

• FIFO ensures that the oldest inventory items are used or sold before newer ones, reducing the risk of obsolescence and spoilage.
• It is commonly used in industries where products have a limited shelf life, such as food and pharmaceuticals.
• FIFO can affect financial statements and tax calculations, typically resulting in higher reported profits during periods of rising prices.

What is FIFO?

First in first out (FIFO) is an accounting and inventory management method where the items that were acquired or produced first are the first to be used, sold, or removed from inventory. This method is based on the principle that the oldest inventory items are used or sold before the newer inventory items. FIFO is widely used in various industries, particularly those where products have expiration dates or can become obsolete.

Importance of FIFO

Reduces obsolescence and spoilage: FIFO is particularly useful for managing inventory with a limited shelf life, such as perishable goods or products prone to obsolescence. By ensuring that older items are sold or used first, businesses can minimize waste and reduce the risk of holding unsellable stock.

Simplifies inventory tracking: FIFO makes it easier to track and manage inventory, as it aligns with the natural flow of goods through most businesses. This method ensures that inventory records accurately reflect the physical movement of goods.

Complies with accounting standards: FIFO is an accepted method under generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). It is commonly used by businesses for financial reporting and tax purposes.

How FIFO works

Under FIFO, inventory costs are assigned based on the order in which items are added to inventory. When goods are sold or used, the cost of the oldest inventory items is assigned to the cost of goods sold (COGS). The remaining inventory is valued based on the cost of the most recent purchases.

For example, consider a company that sells widgets and uses the FIFO method. If the company purchases 100 widgets at $10 each in January and another 100 widgets at $12 each in February, the cost of goods sold for the first 100 widgets sold will be $10 each. The remaining inventory will be valued at $12 each.

Effects on financial statements

FIFO can have significant effects on a company’s financial statements, particularly during periods of rising or falling prices:

Rising prices: During periods of inflation, FIFO typically results in lower COGS and higher ending inventory values compared to other methods like last in first out (LIFO). This leads to higher reported profits and potentially higher taxes.

Falling prices: Conversely, during periods of deflation, FIFO results in higher COGS and lower ending inventory values, leading to lower reported profits.

Tax implications: The choice of inventory valuation method can impact a company’s taxable income. FIFO often results in higher taxable income during periods of rising prices, as the older, lower-cost inventory is matched against current revenues.

FIFO vs. other inventory methods

Last in first out (LIFO): LIFO assumes that the most recently acquired items are sold or used first. This method can lead to lower reported profits and lower taxes during periods of rising prices, as it matches higher-cost inventory with current revenues. However, LIFO is not permitted under IFRS.

Weighted average cost (WAC): WAC calculates the average cost of all inventory items and assigns this average cost to both COGS and ending inventory. This method smooths out price fluctuations but may not reflect the actual physical flow of goods.

Specific identification: This method tracks the cost of each individual item in inventory and assigns this cost to COGS when the item is sold. It is suitable for businesses with unique or high-value items but is impractical for large volumes of homogeneous goods.

Related topics

To further understand the implications and applications of FIFO, consider exploring these related topics:

• Inventory Management: Strategies and techniques for managing inventory levels, including just-in-time (JIT) and safety stock management.
• Cost of Goods Sold (COGS): An overview of how COGS is calculated and its impact on financial statements.
• Accounting Methods: Different accounting methods for inventory valuation and their effects on financial reporting.
• Supply Chain Management: Understanding the broader context of inventory management within supply chain operations.

FIFO is a widely used and accepted method for managing inventory and valuing inventory costs. Exploring these related topics can provide a deeper understanding of inventory management practices and their impact on business operations and financial reporting.