First in first out (FIFO)

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First in first out (FIFO) is an inventory valuation and cost flow method based on the assumption that items purchased or produced earliest are sold or used first [1]. Under this approach, the cost of goods sold reflects the oldest inventory costs while remaining stock on the balance sheet carries the most recent purchase prices. FIFO provides one of several accepted methods for assigning costs to inventory and calculating cost of goods sold, alongside alternatives such as Last In First Out (LIFO), weighted average cost and specific identification. The method finds particular favor in industries handling perishable goods where physical product flow actually follows a first in first out pattern.

Origins and development

Inventory costing methods emerged as formal accounting practice during the late nineteenth and early twentieth centuries as industrial enterprises grew in scale and complexity. Before standardized approaches existed, businesses often valued inventory using somewhat arbitrary methods that produced inconsistent and sometimes misleading financial statements [2].

The development of cost accounting as a distinct discipline during the early 1900s brought systematic attention to inventory valuation. J. Lee Nicholson and John Whitmore were among the pioneering cost accountants who developed frameworks for allocating manufacturing costs to products. Their work laid foundations for the inventory methods that became standard practice [3].

Regulatory developments cemented FIFO as an accepted method. The Internal Revenue Service recognized FIFO for tax purposes, and the American Institute of Accountants (predecessor to AICPA) endorsed it as conforming to generally accepted accounting principles. International Financial Reporting Standards permit FIFO while prohibiting LIFO, making FIFO the dominant method globally outside the United States where both remain available.

The FIFO principle

The core assumption underlying FIFO holds that goods leave inventory in the same order they entered [4]. When a company sells merchandise or uses raw materials in production, FIFO assigns the oldest available costs to that consumption. Newer costs remain in inventory until older layers are exhausted.

Consider a retailer purchasing identical items at different times and prices. Under FIFO, when customers buy these items, the accounting system charges the earliest purchase costs to cost of goods sold regardless of which physical unit actually left the store. The remaining inventory reflects the most recent purchase prices.

This logical flow often matches physical reality for perishable products. A grocery store rotates stock so older milk sells before newer arrivals spoil. A pharmaceutical distributor ships medications with earliest expiration dates first. Even where physical flow differs, accounting may still follow FIFO conventions.

Calculation methodology

Basic FIFO computation

Applying FIFO requires tracking inventory purchases by date and cost. When goods are sold, the system removes costs in chronological order [5].

A simple example illustrates the approach. A business begins the month with 100 units purchased at ten dollars each. During the month it purchases 150 more units at twelve dollars, then sells 120 units. Under FIFO, cost of goods sold includes all 100 original units at ten dollars (one thousand dollars) plus 20 units from the second purchase at twelve dollars (two hundred forty dollars), totaling one thousand two hundred forty dollars. Ending inventory consists of the remaining 130 units from the twelve dollar purchase.

Periodic versus perpetual systems

FIFO operates somewhat differently under periodic and perpetual inventory systems. Perpetual systems update inventory records with each transaction, applying FIFO layer by layer as sales occur. Periodic systems calculate cost of goods sold at period end, working backward from ending inventory valued at most recent costs [6].

Under perpetual FIFO, each sale immediately consumes the oldest available cost layers. Under periodic FIFO, the total units sold during the period are costed using earliest purchases first. Results typically match, though timing differences can arise in certain circumstances.

Impact on financial statements

Balance sheet effects

FIFO produces inventory valuations closer to current replacement costs than alternative methods. Since ending inventory carries the most recent purchase prices, balance sheet values approximate what the company would pay to replace its stock [7]. This characteristic enhances balance sheet relevance, particularly during periods of changing prices.

During inflation, FIFO inventory values exceed those produced by LIFO. The balance sheet presents higher total assets and higher working capital. Financial ratios based on inventory values such as current ratio and quick ratio show more favorable results.

Income statement effects

Cost of goods sold under FIFO reflects older, often lower costs during inflationary periods. Lower cost of goods sold produces higher gross profit and net income compared to LIFO [8]. This relationship reverses during deflationary periods when prices decline.

Higher reported profits under FIFO mean higher income tax expense, assuming taxable income follows book income. The tax disadvantage during inflation represents a significant consideration when choosing inventory methods. Some analysts view FIFO profits as overstated during inflation since the company must pay more to replace inventory sold at old costs.

Comparison with other methods

FIFO versus LIFO

Last In First Out represents the opposite approach, charging the most recent costs to cost of goods sold while retaining older costs in inventory. LIFO produces lower inventory values and lower profits during inflation. The resulting tax savings made LIFO popular among United States companies when inflation rates were high [9].

International Financial Reporting Standards prohibit LIFO, citing concerns that old inventory costs on the balance sheet distort financial position. Companies reporting under IFRS must use FIFO, weighted average or specific identification. American companies may choose LIFO for tax purposes but must then use LIFO for financial reporting as well (the LIFO conformity requirement).

FIFO versus weighted average

Weighted average cost averages all available inventory costs, applying a single unit cost to both cost of goods sold and ending inventory. This approach smooths out price fluctuations rather than assigning specific cost layers to specific transactions [10]. Results typically fall between FIFO and LIFO during periods of consistently rising or falling prices.

FIFO versus specific identification

Specific identification tracks actual costs of individual items, matching each sale to its true acquisition cost. This method works for unique high-value items like automobiles, jewelry or art but proves impractical for interchangeable commodities. Where applicable, specific identification provides the most accurate cost matching but requires detailed tracking systems.

Industry applications

Perishable goods

Food manufacturers, grocers, pharmaceutical companies and florists commonly use FIFO because their physical inventory flow actually follows first in first out patterns [11]. Selling older stock before newer arrivals minimizes spoilage, expiration and waste. Accounting treatment aligns naturally with operational practice.

Manufacturing

Production facilities often consume raw materials in roughly FIFO order even when accounting for other considerations. Materials received earlier typically enter production before later deliveries. Work in process flows through manufacturing stages sequentially. FIFO cost flow assumptions reasonably approximate physical reality in many manufacturing settings.

Retail operations

Retailers handling non-perishable merchandise may follow FIFO for accounting purposes even when physical inventory flow differs. Customers might purchase from newer shipments displayed more prominently while older stock remains in back rooms. The accounting method need not mirror physical movement so long as it is applied consistently.

Advantages

FIFO offers several benefits that explain its widespread adoption [12]:

Balance sheet accuracy results from carrying inventory at recent costs that approximate current values. Users of financial statements obtain more relevant information about the company's inventory position.

Simplicity and intuitiveness make FIFO easy to understand and explain. The assumption that older items sell first matches common sense expectations about inventory flow.

Global acceptability under both GAAP and IFRS means multinational companies can apply FIFO consistently across all jurisdictions. Companies using LIFO in the United States face reconciliation requirements for international subsidiaries.

Reduced manipulation potential exists because FIFO inventory values depend on objective purchase records rather than management choices about which costs to recognize. Opportunities for earnings management through inventory method selection diminish.

Limitations

Despite its advantages, FIFO presents certain drawbacks [13]:

Higher tax burden during inflation results from reporting higher profits that are subject to income tax. Companies effectively pay taxes on inventory holding gains that merely reflect price increases rather than real economic profits.

Profit overstatement concerns arise because matching old costs against current revenues produces margins that overstate sustainable profitability. Management may be tempted to distribute or consume profits that are needed to replace inventory at higher prices.

Poor matching of current costs with current revenues violates the matching principle that some accountants consider fundamental. Cost of goods sold reflects historical rather than current replacement costs.

Implementation considerations

Record keeping requirements

FIFO requires tracking inventory purchases by date and cost. Businesses must maintain records showing when each batch was acquired and at what price [14]. Modern inventory management systems automate this tracking but smaller operations may find the administrative burden challenging.

Consistency

Accounting standards require consistent application of inventory methods across periods. Changing from FIFO to another method requires justification and disclosure. The cumulative effect of changing methods must be reported, potentially creating significant one-time adjustments to financial statements.

Auditing implications

External auditors verify that companies correctly apply their stated inventory methods. FIFO audits involve testing that cost layers are properly maintained and that the oldest costs are indeed charged to cost of goods sold. Cutoff testing ensures purchases and sales are recorded in correct periods.


First in first out (FIFO) — recommended articles
Cost — Return on investment — Financial planning — Decision making — Investment — Strategy

References

Footnotes

  1. Kieso D.E., Weygandt J.J., Warfield T.D. (2019), pp. 412-418
  2. Stickney C.P., Weil R.L., Schipper K., Francis J. (2009), pp. 267-273
  3. Horngren C.T., Datar S.M., Rajan M.V. (2015), pp. 156-162
  4. Schroeder R.G., Clark M.W., Cathey J.M. (2020), pp. 234-240
  5. Bragg S.M. (2021), pp. 78-85
  6. Kieso D.E., Weygandt J.J., Warfield T.D. (2019), pp. 420-426
  7. Revsine L., Collins D.W., Johnson W.B., Mittelstaedt H.F., Soffer L.C. (2018), pp. 312-318
  8. Horngren C.T., Datar S.M., Rajan M.V. (2015), pp. 168-174
  9. Schroeder R.G., Clark M.W., Cathey J.M. (2020), pp. 245-251
  10. Kieso D.E., Weygandt J.J., Warfield T.D. (2019), pp. 428-433
  11. Muller M. (2019), pp. 89-96
  12. Revsine L., Collins D.W., Johnson W.B., Mittelstaedt H.F., Soffer L.C. (2018), pp. 324-330
  13. Stickney C.P., Weil R.L., Schipper K., Francis J. (2009), pp. 285-290
  14. Bragg S.M. (2021), pp. 112-118

Author: Sławomir Wawak

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