What Does FIFO Stand For?
FIFO stands for ‘First In, First Out’. It is an accounting method used to track the cost of goods sold (COGS).
Under FIFO, the cost of inventory purchased first is recognised first. This method is commonly used in inventory management, particularly for perishable goods.
What Is The FIFO Inventory Costing Method?
The FIFO inventory costing method, or First-In, First-Out, assumes that the earliest items purchased are the first ones sold. This means the cost of the oldest inventory is reflected in the cost of goods sold (COGS), leaving the ending inventory valued at more recent purchase prices.
FIFO is a common method because it aligns with the physical flow of goods in many businesses. It’s also relatively easy to implement and maintain.
In What Situations Is The FIFO Method Most Commonly Used?
The FIFO inventory costing method is most commonly used in businesses that deal with perishable goods or items with a short shelf life. This is because FIFO helps ensure that older inventory is sold first, minimising the risk of spoilage and obsolescence.
How Does The FIFO Method Impact The Cost of Goods Sold (COGS)?
The FIFO method can impact the cost of goods sold (COGS) in the following ways:
- Lowers COGS In Periods Of Rising Prices: When prices are rising, the FIFO method assumes that the cost of goods sold is based on the older, lower purchase prices. This results in a lower COGS and consequently, a higher net income.
- May Not Reflect Current Inventory Costs: Since FIFO uses the historical cost of older inventory, the COGS may not accurately reflect the current cost of replacing the inventory that has been sold. This can be a disadvantage when there have been significant price increases.
Why Might A Business Choose FIFO Over Other Inventory Costing Methods?
The following are some of the reasons why businesses might choose FIFO over other inventory costing methods:
- Alignment With Inventory Flow: FIFO adheres to the well-established principle of matching costs to the goods sold. This means the cost of the earliest purchases is reflected in the cost of goods sold (COGS), which aligns with the assumption that older inventory is sold first.
- Potential Tax Benefits: In periods of rising prices (inflation), FIFO can generate a lower COGS due to the use of older, lower-cost inventory for cost calculations. This can translate to higher reported profits and potentially lower tax liabilities.
- Administrative Efficiency: Compared to other costing methods like weighted average cost (average cost) or LIFO (Last-In, First-Out), FIFO is relatively easier to implement and maintain, reducing administrative burdens for accounting teams.
Can The FIFO Method Affect A Company’s Financial Statements? If So, How?
The FIFO inventory costing method can affect a company’s financial statements in a few ways:
- Balance Sheet: FIFO can influence the value of a company’s ending inventory. During periods of inflation, FIFO results in a lower ending inventory valuation because the cost of goods sold reflects older, lower purchase prices. This can lead to lower total current assets on the balance sheet.
- Income Statement: Under FIFO, the cost of goods sold (COGS) is generally lower in periods of rising prices. This leads to higher reported net income on the income statement. However, it’s important to note that this higher net income might not reflect the actual replacement cost of the inventory that was sold.
