What it means
The idea behind FIFO is simple: whatever came in first leaves first. Imagine a shelf of milk where the oldest cartons are placed at the front and sold before the newer ones.
For perishable and dated goods this is also the physically sensible way to handle stock. In accounting, FIFO is a cost flow assumption, which means it applies even if the physical goods are not actually moved that way.
When prices rise, the earliest and cheapest purchases are matched to sales first. That gives a lower cost of goods sold, a higher profit and a higher closing inventory value than other methods.
The abbreviation is used beyond inventory. Computer scientists use FIFO queues to process tasks in the order they arrive, and tax professionals apply FIFO rules to decide which purchase lot of a share or crypto asset is treated as sold first.
In each case, the principle is the same, though the rules about cost matching differ. FIFO is permitted under both major accounting frameworks, and it is widely used worldwide partly because LIFO (last in, first out) is banned under international standards.
The method is also simple to audit, since the closing inventory is made up of the most recent purchases and so reflects current prices. The main drawback appears in inflationary periods, because the profit reported under FIFO includes gains from holding stock as prices rose.
That can lead to higher tax bills than methods that match newer costs against sales. Managers should understand that choice of method affects reported profit, even though cash is unchanged.
Choosing an inventory method is a policy decision that should be applied consistently from year to year. Changing from one method to another requires disclosure and usually a restatement of earlier figures, because otherwise reported profit would not be comparable.
Auditors will check that the method matches the way the business actually buys and tracks its stock.
In practice
Real-world examples
Example 1
A supermarket stacks new deliveries of yoghurt behind existing stock so the oldest pots are sold first. Its accounting records follow the same rule, so the cheapest older batches are expensed first. Staff are trained to pull from the front, which keeps the physical and accounting flows aligned.
Example 2
A software team runs a support desk that handles tickets strictly in order of arrival. The queue is a FIFO system, and managers measure the time each ticket waits. Managers use the average waiting time as a service quality measure.
Example 3
An investor sells part of her holding of a company share that she bought at three different times. Under FIFO, the earliest purchase is treated as sold first, which determines the taxable gain. A different matching rule, such as specific identification, would produce a different taxable gain.
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
Cost of goods sold (FIFO) = Cost of the oldest units, taken in order of purchase, up to the units sold
Ending inventory = Cost of the most recent units remaining
Tall Pines Gardening, a fictional shop, buys 100 spades at $10 each in January and 100 more at $12 in February, then sells 150. Under FIFO, the first 100 units cost $10 each and the next 50 cost $12 each. Cost of goods sold is (100 x $10) + (50 x $12) = $1,000 + $600 = $1,600. Ending inventory holds the remaining 50 units at $12, so it is worth 50 x $12 = $600. Total purchases of $2,200 are split into $1,600 of cost of goods sold and $600 of inventory.Case study
Seen in the real world
Sandstone Hardware is an illustrative, fictional chain that buys timber in bulk, and prices rose steadily throughout the year. The owner could not understand why reported profit was so high while the cash balance barely moved.
His accountant explained that under FIFO the older, cheaper timber was being charged to cost of goods sold, while replacement stock was costing noticeably more. Reported profit looked strong, but replacing what had been sold required more cash than the books suggested.
In the illustrative follow-up, Sandstone began budgeting for replacement costs and revised its selling prices more quickly. The owner learned to read the profit figure alongside a stock replacement forecast rather than in isolation. He now asks for both the reported profit and the replacement cost view whenever the accounts are discussed.
Watch out
Common mistakes
- Believing FIFO is only valid if goods physically move in that order, when it is a cost flow assumption that applies regardless.
- Switching inventory methods without noting the effect on profit and tax.
- Assuming FIFO and LIFO produce the same profit, when they diverge whenever prices change.
Questions
People also ask
What does FIFO stand for?
It stands for first in, first out, meaning the oldest items are treated as the first ones sold or used.
Does FIFO give higher profit when prices are rising?
Yes, because the older, cheaper costs are matched to sales, which lowers cost of goods sold.
Is FIFO allowed under international standards?
Yes, it is accepted, and unlike LIFO it is permitted under international financial reporting standards.
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