What is the first-in-first-out method?

FIFO represents an easy-to-understand inventory valuation method that assumes the first items purchased or produced are sold first. In theory, this means that the oldest inventory ships to customers before new inventory.

To calculate the value of ending inventory, the cost of goods sold (COGS: cost of goods sold or cost of selling ) of the oldest inventory is used to determine the value of ending inventory, regardless of any recent changes in costs.

How the FIFO inventory valuation method works

Because business inventory is considered an asset, businesses need to calculate cost of goods sold at the end of the accounting period or fiscal year. Ending inventory value affects a business's balance sheet and inventory write-offs.

In general, newer inventory usually costs more than older inventory due to inflation. If the FIFO method is used, ending inventory tends to be worth more because lower value items are sold first. Additionally, inventory remaining at the end of the fiscal year does not impact cost of goods sold (COGS).

Because FIFO is designed for inventory accounting purposes and provides a simple formula to calculate the value of ending inventory. But in many cases, what is received first is not always sold and delivered first.

Unless the goods sold by the enterprise have a short shelf life, are perishable or are easily obsolete (such as fresh food, fruit juice drinks, certain chemical raw materials, pharmaceutical products, etc.), the FIFO method has a dual advantage. It is a reasonable inventory management and calculation of ending inventory. A simple way to value.

By calculating inventory values that match the natural movement of inventory throughout the supply chain, businesses can track and regulate quality and offset high carrying costs caused by storing inventory that is obsolete or no longer available for sale (also known as dead inventory) risk.

While this is the simplest and most common valuation method, the disadvantage of using the FIFO method is that it can cause significant differences when COGS increases significantly.

If product costs triple, but finance staff use values from months or years ago, profits will take a hit. It also doesn't offer any tax benefits unless prices fall.

Example of using FIFO to calculate inventory

Under the FIFO cost flow assumption, you use the cost of opening inventory and multiply the cost of sales by the amount of inventory sold.

For example, a pet food store purchased 80 boxes of vegan pumpkin dog food for $3 per box. Later, she bought 150 more boxes for $4 each because the supplier's price had increased.

The store now has 230 boxes of dog food in stock.

Among them, 100 boxes of dog food have been sold.

Using the FIFO inventory valuation method, assume that the store sells all 80 boxes before entering new inventory. Therefore, on her balance sheet, her total cost of goods sold (100 boxes) will be:

Cost of sales = (original number of units x their value) + (remaining units purchased for the second time x their value)

Cost of sales = (80 x $3) + (20 x $4) = $320

Here, the cost of the oldest inventory item is used first in the COGS calculation (initial purchase of 80 boxes at $3 per box), and the remaining 20 boxes use the second purchase cost of $4 per box. Then calculate the value of the remaining or ending inventory (130 boxes):

Closing inventory value = remaining goods x their value

Ending inventory value = 130 x $4 = $520

We will share with you the details of the advantages and disadvantages of the first-in, first-out inventory accounting method and its comparison with other cost accounting methods (such as the common weighted average method) later.