First-In-First-Out (FIFO) Cost

Definition

First-In-First-Out (FIFO) is a method used in inventory management and accounting for valuing stock or inventory. Under FIFO, it is assumed that the earliest units of inventory are sold or used first. This means that the cost of the oldest inventory items are assigned to cost of goods sold (COGS), while the cost of the most recent purchases remains in ending inventory.

Examples

Retail Store Scenario:
- A retail store buys 100 units of a product at $10 each in January and another 100 units at $12 each in February. By March, the store sells 150 units. Under FIFO, the cost of goods sold (COGS) is calculated by taking the cost of the earliest inventory first:
  - 100 units from January at $10 = $1,000
  - 50 units from February at $12 = $600
  - Total COGS = $1,600
Manufacturing Example:
- A factory purchases raw materials multiple times during a year. In January, it buys 500 units at $5 each, in April, 300 units at $6 each, and in July, 200 units at $7 each. By December, it has used 700 units. The valuation follows:
  - 500 units from January at $5 = $2,500
  - 200 units from April at $6 = $1,200
  - Total cost of materials used = $3,700

Frequently Asked Questions

Q: Why use FIFO over other methods?

A: FIFO often reflects the actual flow of goods, making it easier to match revenue with the appropriate costs. Additionally, during periods of inflation, FIFO usually results in higher ending inventory values and lower cost of goods sold which can lead to higher taxable income but better matching of current costs with revenue.

Q: How does FIFO impact financial statements?

A: FIFO impacts both the balance sheet and the income statement by potentially increasing the value of inventory and earnings during periods of rising prices because older, lower-cost inventory is charged to COGS.

Q: Are there any drawbacks to FIFO?

A: During periods of inflation, FIFO can overstate profitability due to lower historical costs being matched against current revenues. This higher reported profit can result in higher taxes.

Q: How does FIFO compare with Last-In-First-Out (LIFO)?

A: LIFO assumes that the latest inventory items are sold or used first. This can lead to lower profits in times of inflation since higher recent costs are matched against revenues, potentially resulting in lower taxable income compared to FIFO.

Q: What industries commonly use FIFO?

A: FIFO is widely used in industries where the products have a short shelf life such as food and beverages, pharmaceuticals, and any industry where inventory must be sold in the order it was produced to avoid obsolescence.

Last-In-First-Out (LIFO): An inventory valuation method assuming that the latest items added are the first to be used or sold. Often contrasts with FIFO, especially in tax and financial reporting.
Next-In-First-Out (NIFO): An inventory valuation method assuming the next inventory items to be received are the first to be sold. NIFO is less common in accounting applications but used in theoretical discussions.
Cost of Goods Sold (COGS): The direct costs attributable to the production of goods sold by a company. This includes the cost of materials and labor directly used to create the good.
Process Costing: An accounting methodology that traces and accumulates direct costs, and allocates indirect costs of a manufacturing process. Can be used with FIFO to value work in progress.

Online References

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- This textbook offers thorough insights into various accounting principles, including inventory costing methods like FIFO, LIFO, and others.
“Managerial Accounting” by Garrison, Noreen, and Brewer
- A comprehensive guide on managerial accounting, offering practical examples of FIFO in inventory and financial decision-making processes.
“Financial Accounting” by Weygandt, Kimmel, and Kieso
- This book balances coverage of the financial accounting topics with accessible examples, including detailed sections on inventory valuation methods.

Accounting Basics: “First-In-First-Out (FIFO) Cost” Fundamentals Quiz

### Why would a company choose First-In-First-Out (FIFO) accounting method? - [x] To better match the actual flow of items sold. - [ ] To reduce the amount paid in taxes. - [ ] To use the most recent costs first. - [ ] Since it is the only inventory method allowed by GAAP. > **Explanation:** Companies choose FIFO to better match the flow of items sold with their actual usage. The policy helps in mirroring the economic reality where older goods are typically sold first. ### In FIFO, if prices are rising for raw materials, what impact does it have on the ending inventory value? - [x] The ending inventory value tends to be higher. - [ ] The ending inventory value tends to be lower. - [ ] It remains unaffected. - [ ] It will always be the same as LIFO. > **Explanation:** In FIFO, because the oldest (often cheaper) costs are recognized first, the newest (usually higher) costs remain in the ending inventory. This results in an overstatement in the value of ending inventory in times of rising prices. ### What does FIFO stand for in accounting? - [ ] Fixed inventory-for-organization - [ ] Final-input-first-out - [x] First-In-First-Out - [ ] Fast inventory flow-out > **Explanation:** FIFO stands for First-In-First-Out, an inventory valuation method where the first items added to inventory are assumed to be the first items sold or removed from inventory. ### Which type of company would most benefit from using FIFO during times of inflation? - [ ] A technology company with price-stable inventory - [x] A grocery store with perishable goods - [ ] An antique store with non-depreciating inventory - [ ] A construction company with highly variable material costs > **Explanation:** A grocery store benefits the most from using FIFO during times of inflation because it ensures the oldest (and possibly perishable) items are sold first, which aligns well with FIFO’s principle and the nature of perishable goods. ### Which financial statement is directly affected by FIFO valuation? - [x] The balance sheet and income statement - [ ] Only the statement of cash flows - [ ] Only the shareholder’s equity statement - [ ] Only the balance sheet > **Explanation:** FIFO affects both the balance sheet and the income statement. It influences the reported cost of goods sold (COGS) on the income statement and the value of ending inventory on the balance sheet. ### During periods of rising prices, how does FIFO affect net income compared to LIFO? - [x] FIFO generally results in higher net income. - [ ] FIFO results in lower net income. - [ ] FIFO and LIFO result in the same net income. - [ ] Net income is incomparable between FIFO and LIFO during rising prices. > **Explanation:** During periods of rising prices, FIFO results in lower COGS compared to LIFO, leading to higher gross margins and higher net income. ### With FIFO, how are cost of goods sold (COGS) calculated? - [ ] Using the cost of the most recent stock first. - [ ] Averaging the cost of all items in inventory. - [x] Using the cost of the earliest stock first. - [ ] Using the costs based on supplier's input. > **Explanation:** In FIFO, the cost of goods sold is calculated using the cost of the earliest stock first, following the principle that the oldest inventory costs are recognized first. ### What must be true of the stock for FIFO to price the issues accurately? - [x] Stock must be historically priced and dated. - [ ] Stock must be periodically re-evaluated. - [ ] Prices of all stock must steadily rise. - [ ] Stock must be indistinguishable and identical. > **Explanation:** Stock must be historically priced and dated correctly to ensure FIFO can accurately price the issues and maintain order of removal. ### What is a potential tax consequence of using FIFO during inflationary periods? - [x] Higher taxable income. - [ ] Lower taxable income. - [ ] Tax-neutral impact. - [ ] Lower income taxes due to higher COGS. > **Explanation:** During inflationary periods, FIFO can lead to higher taxable income because the older, often lower costs are matched against current revenues, resulting in higher reported profits. ### Which inventory costing method would likely be preferable during periods of deflation? - [ ] Always FIFO - [x] Possibly LIFO - [ ] Always LIFO - [ ] NIFO > **Explanation:** During deflation, LIFO may be preferable because it commonly results in higher COGS and lower taxable income, which can have a beneficial tax effect under those conditions.

Thank you for exploring the complexities of the First-In-First-Out (FIFO) approach with our detailed glossary entry and challenging quiz. Continue your journey to master inventory management concepts!