Among the many inventory valuation methods you can use to determine your cost flow, one method stands out. This method is called First in First Out or FIFO for short. In this article, we’ll explain what FIFO is and how it works.
What is FIFO?
FIFO is a cost flow hypothesis that the first item bought should also be the first that gets sold. This is in fact in theory the most accurate inventory valuation method as for most companies, this matches their actual flow of goods the most.
According to FIFO, the first item that the company buys (first in) is also the first to be sold (first out). What this means is that the cost of older inventory gets assigned to the cost of sold goods, while the cost of newer inventory gets assigned to the ending inventory. As a result, the items left in the inventory are accounted for at the cost they were last obtained for and the asset recorded on the balance sheet will most closely match the actual cost for which it could be purchased in the market.
How does FIFO Work – an Example
So how does FIFO work in practice? Let’s take a company, we’ll call it Gothic and how they might estimate their inventory value for the period between 1st and 30th September.
|Sep 1||Beginning Inventory||50 items @ $20.00 per unit|
|5||Sale||15 items @ $17.50 per unit|
|11||Purchase||25 items @ $16.00 per unit|
|17||Sale||30 items @ $22.00 per unit|
|23||Purchase||20 items @ $17.50 per unit|
|26||Purchase||50 items@ $20.50 per unit|
|29||Sale||75 items @ $21.00 per unit|
Okay, let’s take a look at what we got here:
|Units Available for Sale||= 50 + 25+ 20+ 50||= 145|
|Units Sold||= 15+ 30+ 75||= 120|
|Units in Ending Inventory||= 145− 120||= 25|
|Cost of Goods Sold||Units||Unit Cost||Total|
|Sales From Sep 1 Inventory||50||$20.00||$1,000|
|Sales From Sep 11 Purchase||25||$16.00||$400|
|Sales From Sep 23 Purchase||20||$17.50||$350|
|Sales From Sep 26 Purchase||50||$20..50||$1,025|
|Ending Inventory||Units||Unit Cost||Total|
|Inventory From Sep 29 Sale||25||$20.50||$512.5|
Difference Between FIFO and LIFO
A comparison between FIFO and another inventory valuation method called LIFO presents itself automatically. So, what is different here?
Unlike FIFO, which, as we already explained, looks at the oldest items first for expense, LIFO does this with the most recent ones instead.
We’ll get more into LIFO and how this method is calculated another time. For now, just remember that FIFO and LIFO methods will give you different inventory and cost of goods sold (COGS).
Problem with FIFO
The biggest issue with FIFO is that, since it starts to expanse at the beginning of the inventory, it doesn’t match the income statement quite so well. This results in the revenue from the sale being often matched with a cost that is outdated.
For instance, if our company would purchase two trucks, one at $75,000 and the other at $90,000, under FIFO the sale of one of them would lead to an expense of $75,000, which is an outdated cost.
First In First Out method is the most natural inventory valuation method there is, which is why so many companies (including imaginary ones like ours) use it. That being said, it is not without it’s flaws, as we’ve seen.
What do you think of FIFO? Do you use this method or some other? Let us know in the comments below and don’t forget to sign up for a free Purchase Order Plus trial.