What it means
When a business buys the same item repeatedly at different prices, it has to decide which cost to use when a unit is sold. FIFO answers by assuming the earliest purchases are consumed first, so the oldest costs flow into cost of goods sold and the newest costs stay in inventory.
This is a costing assumption rather than a claim about which physical box left the shelf, though for perishable goods the two usually coincide. The consequences show up clearly when prices are moving.
In a period of rising costs, FIFO charges the older and cheaper costs against revenue, which produces a higher reported profit and a higher inventory value on the balance sheet. In a period of falling costs the effect reverses, and profit is squeezed because the older, more expensive stock is being charged to sales.
The main alternatives are weighted average cost, which blends all purchase prices into a single running rate, and Last-In First-Out, which assumes the newest stock sells first. Weighted average smooths out price volatility and is common in commodities and process industries, while Last-In First-Out is prohibited under International Financial Reporting Standards, which is a large part of why FIFO dominates outside the United States.
Because FIFO leaves the balance sheet holding recent costs, the inventory figure tends to be closer to current replacement value than under the alternatives. That makes the balance sheet more informative, at the cost of an income statement that pairs old costs against today's selling prices.
Consistency is the practical rule that matters most. Once a business picks a costing method it must apply it consistently and disclose it, because switching methods changes reported profit without anything real having changed in the business.
In practice
Real-world examples.
Example
A supermarket rotates dairy products so the oldest cartons sit at the front of the chiller. Its accounting method mirrors the physical practice, so the cost of a sold carton is the cost of the oldest one on hand.
Example
A builders' merchant sees cement prices rise 18% over a year. Because it uses FIFO, its reported gross margin looks unusually strong, and the finance director warns the board that the effect is a costing artefact rather than a genuine improvement in trading.
Example
A pharmaceutical wholesaler must sell by expiry date, so physical FIFO is a regulatory requirement rather than a choice. Aligning the costing method with the physical flow keeps the records straightforward and simplifies the annual audit.
Think of it
“FIFO assumes you sell old stuff first-like rotating milk at a grocery store, oldest goes out first.
Formula
Calculation
Under FIFO, cost of goods sold is charged at the cost of the oldest units held, and closing inventory is valued at the cost of the most recent purchases.
A coffee roaster starts March holding 200 bags of green beans that cost $10 each, a total of $2,000. During the month it buys 300 more bags at $12 each, a total of $3,600, so it has 500 bags available at a total cost of $5,600.
The roaster sells 400 bags in March. Under FIFO the cost of those sales is the 200 original bags at $10, which is $2,000, plus 200 of the newer bags at $12, which is $2,400, giving cost of goods sold of $4,400. The 100 bags remaining all come from the newer batch, so closing inventory is 100 x $12 = $1,200, and $4,400 + $1,200 = $5,600 confirms that every dollar of cost has been allocated.Case study
Seen in the real world.
What follows is an illustrative and fictional example. Kestrel Copper Supplies, an invented distributor of electrical cable, used FIFO and traded through a year in which copper prices climbed steadily. Its gross margin rose from 21% to 29% without a single change to its price list, because it was charging last year's cheaper metal against this year's higher selling prices.
Encouraged by the apparent improvement, the fictional management team approved a new depot and two extra sales roles. When copper prices stabilised the following year, the old low cost stock ran out, cost of sales caught up with reality and gross margin dropped back to 22%, leaving the business carrying costs it had committed to on the strength of a paper gain.
The lesson Kestrel drew was not that FIFO is wrong, since it is a perfectly acceptable method, but that in a period of moving prices management needed a second view. The company began reporting a replacement cost margin alongside the statutory FIFO figures, which showed the true trading position and stopped a repeat of the mistake.
Watch out
Common mistakes.
- Believing FIFO describes how goods physically move, when it is purely an assumption about which costs are charged to sales.
- Reading a rising FIFO gross margin in an inflationary period as improved trading, when it is largely the effect of old costs meeting new prices.
- Switching between FIFO and weighted average to smooth results, which breaks comparability and will be questioned by auditors.
Questions
People also ask.
Is FIFO allowed everywhere?
FIFO is permitted under both International Financial Reporting Standards and United States rules, which is why it travels well for groups reporting in more than one country.
Does FIFO give a higher profit than weighted average?
Usually yes when costs are rising, and usually lower when costs are falling, because FIFO always charges the oldest costs first.
Which method should a small business choose?
FIFO is the sensible default because it matches physical stock rotation, is easy to explain and is accepted almost everywhere.
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