What Does FiFo Mean & How Does it Work?

Understanding FIFO (First-In, First-Out)

What is FIFO?

FIFO, or First-In, First-Out, is an inventory management method where the oldest inventory items are sold or used first. This system ensures that the goods purchased or produced first are the first ones to be removed from inventory. FIFO is commonly used in industries where products have a limited shelf life, such as food, pharmaceuticals, and cosmetics, ensuring that older items are used before they become obsolete.

How Does FIFO Work?

Under the FIFO method, when a sale is made or inventory is used, the cost of the oldest inventory is assigned to the cost of goods sold (COGS). This means that the remaining inventory on the balance sheet reflects the cost of the most recent purchases. Here’s a simple example to illustrate FIFO:

1. Purchase 1: 100 units at $10 each
2. Purchase 2: 100 units at $12 each
3. Sale: 150 units

Using FIFO, the COGS would be calculated as:

• 100 units from Purchase 1 at $10 = $1000
• 50 units from Purchase 2 at $12 = $600
• Total COGS: $1600

The remaining inventory would be 50 units from Purchase 2 at $12 each, totaling $600.

Advantages of FIFO

• Realistic Inventory Valuation: Since older costs are matched against current sales, FIFO often results in a higher inventory value during periods of rising prices.
• Simplicity: FIFO is straightforward to understand and implement.
• Compliance: Many accounting standards and tax regulations favor FIFO.

Disadvantages of FIFO

• Higher Taxes: In times of inflation, FIFO results in higher profits and, consequently, higher taxes.
• Not Always Reflective of Current Costs: FIFO can sometimes present outdated costs in COGS, which might not reflect the current market conditions.