First-in first-out inventory cost flow method (FIFO)

FIFO is an inventory cost flow method under which the first items which were purchased meant to be resold or used first, as the name implies (first-in first-out). In other words, the usage (outflows) of inventory should be in the order of its inflows and the ending inventory cost will be computed accordingly to the prices of most recent acquisitions. This information is very important to any entity because the cost of products acquired should be recognized as cost of goods sold on the income statement and it impacts the company’s income. This method is commonly used especially for goods with relatively short expiration dates.

To illustrate how FIFO works, let’s assume that an entity just started a business and doesn’t have any inventory at the beginning of a period yet, but purchased 100 units at $16 per unit and 200 units at $22 per unit in the first and second months of the year. They sold 50 of those units after the first purchase and 160 more units after the second purchase during the period.

Under the periodic inventory system (FIFO) when the computation of inventory levels should be done at least annually the entity will get the following results:

Under the perpetual inventory system (FIFO) when the computation of inventory levels should be done after each sale the entity will get the following results:

Note: under both periodic and perpetual inventory systems while using the FIFO method the amount of cost of goods sold are the same and the amount of ending inventory are the same as well. Therefore, it generally doesn’t matter whether to use periodic or perpetual inventory systems under the FIFO accounting method. However, periodic calculation typically is easier and faster to perform while perpetual ones are more detailed which require more calculations to be involved.

Even if name of the FIFO accounting method apply that first item in and the first item out, but it doesn’t necessary mean that the company should mark each item which came first to make it first out rather the items prices will work that way. In case of identical acquisitions the actual item itself, especially if an expiration is not an issue, might not be exactly the very first one to be used or purchased. Sometimes the firm even cannot control much these happenings. For example, customers might take any product from the shelf regardless when it was purchased. In fact, usually they will choose the one which was bought later. However, for accounting purposes the store will assume that all items were sold in order of their incomings.

Advantages of FIFO method

- one of the easiest and logical inventory methods
- it approximates the actual flow of the goods
- put obstacle to manipulation of income
- closely match current to ending cost of inventory

Disadvantages of FIFO method

-fails to match current cost against current revenues
- gives the lowest amount of cost of goods sold (COGS)
- make a company’s income higher compare to other inventory cost flow methods, such as LIFO and Weighted Average