What is First In, First Out (FIFO)?
First in, first out (FIFO) is one way companies estimate the value of inventory without tracking each item — by assuming the oldest goods are sold first.
🤔 Understanding first in, first out (FIFO)
Things are always changing in business, including the cost of raw materials, intermediate goods, and wholesale products. That means every item in a company’s storeroom or warehouse was probably purchased at a different price. As a result, keeping track of how much money is tied up in inventory (items held in stock for future production or sale) can be a challenge. One option for tracking the value of what’s in stock is to assume the oldest products on the shelf are the ones you push out the door first. This first in, first out (FIFO) method is a common accounting technique to avoid tracking every individual piece of inventory as it is sold.
To avoid waste, restaurants likely want to use products in the order they expire — which usually means in the order they were received. Most managers can’t track every individual fruit or vegetable as it comes in and out. A restaurant may want to use the first in, first out (FIFO) method to track the value of its inventory. Even if the first products that went into storage aren’t the first to come out, this method provides a good estimate.
First in, first out (FIFO) is like waiting in line...
When a new iPhone model comes out, some people wait for hours or even camp overnight to get their hands on it. When the store opens, eager customers make their purchases in the order they lined up. If everyone respects the line etiquette, customers follow an informal first come, first served rule. Similarly, FIFO assumes the first goods a company purchases are the first ones it sells.
How does FIFO work?
Most retailers order items before consumers buy them. Those goods are put on shelves or stored in a warehouse until they sell. These finished products, as well as the parts and materials required to make them, show up on the company’s balance sheet as an asset called inventory.
When a sale occurs, the income shows up on financial statements as revenue. It also means that inventory declines. To keep its books in order, the company needs to reduce the recorded value of its inventory. The company also needs to reduce its income to account for the cost of goods sold (money it spent to directly create the product or service sold). For instance, imagine a company buys something for $50 and sells it for $100. Its gross revenue is $100, but it needs to subtract $50 to figure out how much it really made on the sale.
How does a company determine the amount by which to reduce inventory and income? That’s where the FIFO accounting method comes in. Because the price the company paid to wholesalers might change with each order, the COGS also changes with each sale. To deal with that, FIFO counts the cost of the product that has been in the inventory account the longest. In other words, it assumes the assets the company made or bought first are sold first.
How do you calculate FIFO?
It is helpful to walk through an example to understand how first in, first out (FIFO) works.
Let’s imagine a fictional gas station gets a weekly delivery to top off its 10,000-gallon tank. The cost of the gasoline changes whenever global oil markets move.
For simplicity, let’s assume the tank was empty when the first delivery came. Here are the invoices for last month:
|Delivery Date||Price per Gallon||Gallons Delivered||Total Cost of Delivery|
|Feb. 3, 2020||$2.36||10,000||$23,600|
|Feb. 10, 2020||$2.32||8,000||$18,560|
|Feb. 17, 2020||$2.34||6.500||$15,210|
|Feb. 24, 2020||$2.37||7,500||$17,775|
In February 2020, the gas station bought 32,000 gallons of gasoline for $75,145. Say it also sold 22,000 gallons of that gas, leaving 10,000 in inventory. How much does the balance sheet show as the value of that inventory?
To figure that out using the FIFO method, you need to subtract the sales from the oldest purchases first.
During the first week, the gas station sold 8,000 gallons (that’s why the tank needed 8,000 gallons on Feb. 10). You need to assign a cost of $2.36 per gallon to those sales for an inventory reduction of $18,880.
In the second week, there were 6,500 gallons sold. First, you need to assign $2.36 per gallon for the first 2,000 gallons (10,000 from the first delivery, minus the 8,000 gallons from the previous week). That’s $4,720. Then, for the remaining 4,500 gallons, use the $2.32 price from the second delivery. That’s $10,440 and leaves 3,500 gallons from that delivery in inventory.
Finally, we have 7,500 gallons in the third week. First, you assign 3,500 gallons to the second week’s price to finish off that delivery. That’s $8,120. Then, you assign the other 4,000 gallons to the next delivery price of $2.34, which is $9,360.
When you add it all up you get: $18,880
- $9,360 = $51,520
That means that the remaining inventory is worth $23,625 ($75,145 total costs - $51,520 of COGS) using the FIFO method.
What is the difference between FIFO and LIFO?
One alternative to first in, first out (FIFO) accounting is the last in, first out (LIFO) method.
With FIFO, you reduce inventory according to the order it was purchased — The oldest items in stock are assumed to sell first. Under the alternative accounting method called LIFO, you instead assume the inventory you bought most recently sells first.
LIFO accounting assumes that inflation and other factors push the cost of inventory up over time. This method also results in a more considerable cost of goods sold (COGS) line item, which reduces net income (a type of profit). One reason a smaller net income might be desirable for a company is to defer taxes.
What is the difference between FIFO and average cost inventory?
Another way to value inventory is to determine the average cost of the inventory.
While the first in, first out (FIFO) method is generally considered to mimic the actual flow of products better, the average cost method can be easier to calculate. Both approaches tend to generate similar values unless there is a substantial change in the price of inventory during the accounting period.
To determine the value of inventory assets using the average cost method, you simply divide the total costs paid for inventory items by the number of units received.
The result is the average price per unit of products the company purchased over the accounting period. Multiplying that average cost by the number of units that are not sold provides the value of the inventory still in stock at the end of the period.
What is the difference between FIFO and specific inventory tracing?
A final alternative to the first in, first out (FIFO) method is called specific inventory tracing (or specific identification). In this method, the company tracks the cost that it pays for each individual item in stock.
Say a customer buys a pair of sandals in a shoe store. With the FIFO method, the company’s financial statements would show the acquisition cost associated with that sale as the price of the oldest pair of those shoes that remained in the inventory system.
But the actual pair of sandals that went out the door might have just arrived that morning. With a specific inventory tracking system, the acquisition cost on the books would match the actual amount the retailer paid for that particular pair of shoes.
What are the advantages and disadvantages of FIFO?
The first in, first out (FIFO) method of inventory valuation is a widely used and accepted accounting standard. There are pros and cons to using this technique.
- It is commonly used, allowing more relevant comparisons between companies.
- It is a structured system, which minimizes a company’s ability to misstate profits and losses.
- It is generally an easy concept to grasp.
- It tends to mimic actual operations, as companies typically try to sell older products first. This implies that the real inventory value is close to the reported value.
- Since prices tend to rise over time, FIFO results in smaller costs of goods sold (COGS). This tends to increase net profit on financial reports. For a company seeking to show investors how valuable the business is, higher net profits can lead to a higher estimate of what the company is worth.
- Tracking which invoices are still open, which is necessary if inventory items stretch into multiple accounting periods, can be cumbersome and lead to clerical errors.
- By minimizing inventory costs, FIFO increases reported net income, which can result in higher tax payments relative to other methods.
- If the cost of inventory changes a lot during the accounting period, FIFO may cause a company to incorrectly estimate profits. Say the cost of an inventory item increases from $10 to $20 per unit. The company sells this product for $20. While the company still has items it paid $10 for in inventory, financial statements will suggest the company is getting $10 of profit on each item. It might be difficult to see that those profits only exist until the $10 inventory items are depleted.
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