What Is FIFO Method: Definition and Example
FIFO stands for “First-In, First-Out”. It is a method used for cost flow assumption purposes in the cost of goods sold calculation. The FIFO method assumes that the oldest products in a company’s inventory have been sold first. The costs paid for those oldest products are the ones used in the calculation.
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How Do You Calculate FIFO?
To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold.
The “inventory sold” refers to the cost of purchased goods (with the intention of reselling), or the cost of produced goods (which includes labor, material & manufacturing overhead costs).
Keep in mind that the prices paid by a company for its inventory often fluctuate. These fluctuating costs must be taken into account.
For instance, if a business sold 100 units of an item, and 75 units were originally purchased by the company at $10.00 and 25 units were purchased at $15.00, it cannot assign the $10.00 cost price to every unit sold. Only 75 units can be. The remaining 25 items must be assigned to the higher price, the $15.00.
Lastly, the product needs to have been sold to be used in the equation. You cannot apply unsold inventory to the cost of goods calculation.
What Are the Advantages of FIFO?
The FIFO method is considered to me a more trusted method than the LIFO (“Last-In, First-Out”) method. You can read more about why FIFO is preferable here.
The advantages to the FIFO method are as follows:
- The method is easy to understand, universally accepted and trusted.
- FIFO follows the natural flow of inventory (oldest products are sold first, with accounting going by those costs first). This makes bookkeeping easier with less chance of mistakes.
- Less waste (a company truly following the FIFO method will always be moving out the oldest inventory first).
- Remaining products in inventory will be a better reflection of market value (this is because products not sold have been built more recently).
- Higher profit.
- Financial statements are harder to manipulate.
The FIFO method gives a very accurate picture of a company’s finances. This information helps a company plan for its future.
What Are the Disadvantages of FIFO?
The FIFO method can result in higher income tax for a business to pay, because the gap between costs and profit is wider (than with LIFO).
A company also needs to be careful with the FIFO method in that it is not overstating profit. This can happen when product costs rise and those later numbers are used in the cost of goods calculation, instead of the actual costs.
Sal’s Sunglasses is a sunglass retailer located in Charleston, South Carolina. Sal opened the store in September of last year. Right now, it is just the one location but he may expand in the next couple of years depending on whether he can make good money or not.
January has come along and Sal needs to calculate his cost of goods sold for the previous year, which he will do using the FIFO method.
Here is what his inventory costs are:
Month Amount Price Paid
September 200 sunglasses $200.00 per
October 275 sunglasses $210.00 per
November 300 sunglasses $225.00 per
December 500 sunglasses $275.00 per
Sal sold 600 sunglasses during this time, out of his stock of 1275.
Going by the FIFO method, Sal needs to go by the older costs (of acquiring his inventory) first.
Sal’s COGS calculation is as follows:
200 x $200.00 = $40,000.
275 x $210.00 = $57,750.
125 x $225.00 = $28,125.
COGS Total: $125,875.
Sal’s cost of goods sold is $125,875.
The remaining unsold 275 sunglasses will be accounted for in “inventory”.
Sal can use the cost of goods sold to help determine his profit.
Why Would You Use FIFO over LIFO?
In the United States, a business has a choice of using either the FIFO (“First-In, First Out”) method or LIFO (“Last-In, Last-Out”) method when calculating its cost of goods sold. Both are legal although the LIFO method is often frowned upon because bookkeeping is far more complex and the method is easy to manipulate.
Corporate taxes are cheaper for a company under the LIFO method because LIFO allows a business to use its most recent product costs first. Typically these costs have risen over time. Reduced profit may means tax breaks, however, it may also make a company less attractive to investors.
The value of remaining inventory, assuming it is not-perishable, is also understated with the LIFO method because the business is going by the older costs to acquire or manufacture that product. That older inventory may, in fact, stay on the books forever.
Investors and banking institutions value FIFO because it is a transparent method of calculating cost of goods sold. It is also easier for management when it comes to bookkeeping, because of its simplicity. It also means the company will be able to declare more profit, making the business attractive to potential investors. Lastly, a more accurate figure can be assigned to remaining inventory.
Outside the United States, many countries, such as Canada, India and Russia are required to follow the rules set down by the IFRS (International Financial Reporting Standards) Foundation. The IFRS provides a framework for globally accepted accounting standards, among them is the requirements that all companies calculate cost of goods sold using the FIFO method. As such, many businesses, including those in the United States, make it a policy to go with FIFO.