Guide to FIFO: What Is First in First Out?

The "First In, First Out" principle, abbreviated as the acronym FIFO, is an asset-management method businesses use to reduce product obsolescence and accurately value their inventory. With FIFO, costs and assets that are associated with inventory produced or acquired first are sold first. Businesses use FIFO for cost flow assumption purposes, wherein the oldest assets or inventory will be placed first on an income statement's cost of goods sold (COGS).

FIFO allows companies to track their inventory costs in an accurate way. It also allows them to offset the effect that inflation may have on the value of their unsold assets. In corporate accounting, the cost of inventory is listed as an expense on a company's balance sheet, which counteracts the profit made from the sale of the inventory.

In economies with rising prices and inflation, the costs associated with the oldest assets will likely be lower than the costs associated with the newer assets. Selling the oldest assets or inventory first at the inflated current market inventory value allows these companies to increase the profitability of older items from inflation. It also cuts down on product obsolescence because these companies sell their older inventory first, rather than allowing it to languish in storage.

The LIFO accounting method, "Last in, First Out," is the opposite accounting method to FIFO for managing inventory and assets. Companies that practice the LIFO method sell the last items that they acquired first. This is a common practice of large retailers such as auto dealerships or apparel companies.

The net income of businesses that use the LIFO method will typically be lower than those using the FIFO method. LIFO inventory is often used for tax purposes to enable businesses to pay lower taxes on their earnings. International Financial Reporting Standards (IFRS) forbid the use of the LIFO method.

Among small businesses and even some larger retailers, FIFO is the most widely-used inventory accounting method. This is because there are a number of practical advantages of using FIFO.

1. 1. Accuracy: If you’re looking to compare your business's inventory management with other businesses, using the FIFO method will give you the best picture of your inventory system. This is because this method is the most widely used in many types of businesses.
2. 2. Inventory Cost: The FIFO method gives a business the clearest picture of actual inventory costs. When you sell the oldest inventory first, the expected cost flow and the actual flow of goods gives you the most accurate picture of a business' costs and profit.
3. 3. Reduced impact of inflation: One of the biggest advantages to using the first in first out method is reducing the impact of inflation on your inventory costs. Selling older inventory that was produced when inflation and costs were lower maximizes the profit made on inventory.
4. 4. Reduced obsolescence: Businesses selling their inventory with the FIFO method will be able to clear their older inventory before it becomes obsolete. Once they’ve done that, they can sell their newer inventory. This also allows them to offload any perishable goods without risking them going bad.

Though FIFO is the most commonly-used inventory management system employed by small businesses, there are a few disadvantages.

1. 1. Inaccuracy of costs: Sometimes, FIFO can backfire when it comes to cost accuracy. When the costs of producing or acquiring inventory rapidly increase but your accounting department still measures costs based on the value of inventory from a long time ago, you may not get an accurate picture of your company’s business expenses.
2. 2. Higher Taxes: The FIFO method results in a higher valuation of a company’s current assets, requiring a company to report higher earnings in its yearly income statement. These higher earnings may incur higher taxes owed to the IRS.
3. 3. Competition with other companies: Companies waiting to sell their new, state-of-the-art inventory in favor of selling their older items first may garner less profit because consumers choose to buy new inventory from competitors.

To calculate the Cost of Goods Sold (COGS) using the FIFO method, determine the total cost of your oldest inventory, then multiply that total by the total amount of inventory sold. For example, if a manufacturer produced its first 100 units for $50 each, and the following 100 units for $70 each, the FIFO method would use the older cost to calculate COGS on their financial statements.

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