What it means
When a business buys the same product at different prices over time, it has to decide which cost to attach to each unit sold. The choice does not change the physical goods or the total cost over the life of the business, but it changes how that cost is split between this period's income statement and the balance sheet.
FIFO says: charge the oldest costs first. If prices are rising, the oldest costs are the lowest, so cost of goods sold is lower, gross profit is higher and closing inventory (valued at recent, higher prices) is closer to what it would cost to replace.
If prices are falling, the opposite occurs. The alternatives are weighted average cost, which blends all purchases into a single average and produces results between the extremes, and LIFO (last in first out), which charges the newest costs first.
LIFO is permitted under US GAAP but prohibited under IFRS, because it can leave inventory on the balance sheet at costs from decades ago. In a period of rising prices, LIFO reports lower profit and therefore lower tax, which is its main attraction in the United States.
FIFO's advantages are that it is intuitive, it reflects how most goods actually move, and it gives a balance sheet inventory figure close to current cost. Its disadvantage is that during inflation it matches old, low costs against current selling prices, which flatters gross margin with what economists call inventory holding gains: profit that arises from having bought before prices rose rather than from trading skill.
In periods of rapid input cost inflation, a FIFO business can report strong margins while struggling to fund replacement stock at the new prices. Whichever method a business chooses, it must apply it consistently and disclose it.
Analysts comparing companies check the inventory policy note before comparing gross margins, and in the United States they add back the LIFO reserve to put LIFO companies on a FIFO footing.
In practice
Real-world examples.
Example
A supermarket values its stock on FIFO, which mirrors the way staff rotate goods so that the oldest items sit at the front of the shelf.
Example
A steel fabricator sees its FIFO gross margin jump to 34% from 28% during a year of rising steel prices, then fall back as the cheap stock runs out, and warns its board that the extra profit is not repeatable.
Example
A US company reports under LIFO for tax reasons and discloses a LIFO reserve of $12 million, the amount by which its inventory would be higher under FIFO.
Think of it
“FIFO is like how a grocery store rotates milk-older cartons go in front to be sold first, while newer ones wait in back.
Formula
Calculation
Under FIFO: Cost of Goods Sold = Cost of the oldest units on hand, in purchase order, up to the quantity sold
Closing Inventory = Cost of the most recent units purchased, up to the quantity remaining
Worked example. A bicycle shop's purchases and sales of one model during a quarter:
- 1 April: opening stock of 10 bikes at $300 each = $3,000
- 15 April: buys 20 bikes at $320 each = $6,400
- 10 May: buys 15 bikes at $350 each = $5,250
- During the quarter, sells 35 bikes at $600 each = $21,000 revenue
FIFO cost of goods sold for 35 bikes:
- 10 bikes at $300 = $3,000
- 20 bikes at $320 = $6,400
- 5 bikes at $350 = $1,750
- Total COGS = $11,150
Closing inventory = 10 bikes remaining, all from the 10 May purchase at $350 = $3,500
Gross profit = $21,000 minus $11,150 = $9,850 (46.9%)
Comparison under weighted average: total cost $14,650 for 45 bikes = $325.56 each. COGS = 35 x $325.56 = $11,394; closing inventory = 10 x $325.56 = $3,256; gross profit = $9,606. FIFO reports $244 more profit and $244 more inventory because prices rose during the quarter.
Check: opening stock $3,000 + purchases $11,650 = $14,650 = COGS $11,150 + closing inventory $3,500.Case study
Seen in the real world.
A building materials merchant valued stock on FIFO and enjoyed two years of record gross margins as timber and insulation prices rose sharply. The owner took large dividends on the strength of the profits. The finance manager warned that much of the margin was a holding gain: the merchant was selling stock bought at old prices and replacing it at new ones, and every replacement order consumed more cash than the sale had generated.
When prices peaked and then fell 20% within six months, the merchant was holding stock bought at the top, and the FIFO cost of sales for the following two quarters exceeded selling prices on several lines. Gross margin fell to 11%, below the level needed to cover overheads, and the business needed an emergency overdraft. The owner subsequently tracked margin on a replacement-cost basis alongside the statutory FIFO figure, and dividends were set against the lower of the two.
Watch out
Common mistakes.
- Reading a FIFO gross margin during inflation as a measure of pricing power. Part of it is the gain from having bought early.
- Assuming FIFO must match the physical movement of goods. It is a cost flow assumption; a business can use FIFO for accounting even if physical flow differs, as long as it is consistent.
- Comparing the margins of a FIFO company with a LIFO company without adjusting for the LIFO reserve.
Questions
People also ask.
Which is better, FIFO or weighted average?
Neither is inherently better. FIFO gives a more current balance sheet value; weighted average smooths cost fluctuations. Consistency matters more than the choice.
Is LIFO allowed?
Under US GAAP yes; under IFRS no. Companies reporting under IFRS use FIFO or weighted average.
Does FIFO affect tax?
In rising-price environments FIFO reports higher profit than LIFO or weighted average, and therefore higher tax where the tax rules follow the accounts.
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