First In, First Out (FIFO)

First in, first out (FIFO) is a method of assigning costs to inventory that assumes the units bought or made first are the first ones sold. Under FIFO, the cost of goods sold for a period is based on the oldest costs in inventory, while the units left on hand at the end of the period are valued at the most recent costs. The method is a cost flow assumption: it describes how costs are matched to sales, not necessarily how goods physically move, although for most perishable or fashion items the physical flow really is first in, first out.

FIFO is permitted under both US GAAP and International Financial Reporting Standards, and it is the most widely used method worldwide. IFRS, through IAS 2, allows FIFO and weighted average cost but prohibits last in, first out (LIFO), so FIFO is the main choice for companies reporting outside the United States.

A hardware store starts March with 100 drills that cost $40 each. It buys 200 more on 10 March at $44 each and 150 on 22 March at $48 each. During the month it sells 320 drills at $70 each.

• Goods available for sale total 450 units costing $4,000 plus $8,800 plus $7,200, which equals $20,000.
• Under FIFO the first 320 units sold are the 100 opening units at $40 ($4,000), all 200 units at $44 ($8,800) and 20 of the units at $48 ($960), giving cost of goods sold of $13,760.
• Ending inventory is the remaining 130 units at $48, which is $6,240.
• Sales are 320 times $70, or $22,400, so gross profit is $22,400 minus $13,760, which equals $8,640.

The cost of goods sold and ending inventory together equal the $20,000 of cost of goods available for sale, which is the check for any cost flow method. Under a periodic system, FIFO gives the same answer whether costs are assigned at each sale or only at the end of the month, which is not true of the weighted average or LIFO methods.

When prices are rising, as in the example, FIFO matches older, cheaper costs against current selling prices. This produces lower cost of goods sold, higher gross profit and higher reported net income than LIFO or average cost. It also means ending inventory on the balance sheet is close to current replacement cost, which many analysts see as a more realistic asset value.

The drawback is that part of FIFO profit in inflationary periods comes simply from holding inventory while prices rose, rather than from trading. Critics call these inventory profits or phantom profits. Because profit is higher, US companies using FIFO also pay more income tax when prices are rising than they would under LIFO, which is why some US businesses with large, long-lived inventories prefer LIFO. When prices are falling, the effects reverse.

The main alternatives are LIFO, which assumes the newest units are sold first, weighted average cost, which spreads costs evenly over all units, and specific identification, used for unique, high-value items such as cars or jewelry. FIFO generally gives the highest ending inventory and gross profit in a period of rising prices, LIFO the lowest and weighted average falls between. Whichever method is chosen must be applied consistently and disclosed in the accounting policies note, and a change of method is a change in accounting principle that normally requires retrospective application.

Inventory measured under FIFO must still be checked for declines in value. Under both US GAAP and IFRS, FIFO inventory is carried at the lower of cost and net realizable value, and a write-down is recorded through an allowance to reduce inventory to net realizable value or directly against the inventory account. Comparisons between companies should also allow for the method used, since a FIFO company's inventory turnover will look lower than a LIFO company's in an inflationary period simply because its inventory is valued at higher, more recent costs.