First In, First Out (FIFO) Method Explained

January 30, 2025 08:05 AM PST | By Team Kalkine Media
 First In, First Out (FIFO) Method Explained
Image source: shutterstock

Highlights:

  • FIFO values the cost of goods sold based on the oldest inventory first.
  • The method results in ending inventory being valued at the most recently purchased items.
  • FIFO is commonly used to track the flow of inventory in businesses with perishable goods.

The First In, First Out (FIFO) method is an accounting technique used to determine the cost of goods sold (COGS) and the valuation of ending inventory. Under FIFO, the assumption is made that the first items purchased or produced are the first to be sold. This means that when calculating the cost of goods sold, the oldest inventory items are used up and expensed first.

As a result, the ending inventory, or the unsold goods at the end of the accounting period, is valued at the most recently purchased items. This can have a significant impact on financial statements, especially during periods of inflation, where the cost of newer inventory may be higher than older stock.

FIFO is particularly useful in industries dealing with perishable goods, such as food and pharmaceuticals, where older inventory must be sold before newer stock to avoid spoilage. By using the FIFO method, businesses ensure that their inventory turnover is logical, and the financial reports reflect the true cost of the goods sold based on the aging of stock.

One of the advantages of FIFO is that it provides a more accurate reflection of the current market value of the remaining inventory since it is valued based on newer purchases. It also tends to produce a higher net income during inflationary periods, as older, less expensive inventory is matched with current revenues.

The FIFO method contrasts with other inventory valuation methods, such as Last In, First Out (LIFO) and Weighted Average Cost, each of which can yield different financial results and tax implications.

Conclusion: FIFO is a widely used accounting method that ensures the oldest inventory is sold first, providing a logical and systematic way to manage inventory and report financials. While it can increase net income in certain market conditions, it also aligns with practical business needs, especially in industries where product freshness and turnover are key. Understanding how FIFO affects both the cost of goods sold and inventory valuation is crucial for accurate financial reporting.


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