What it means
Businesses that hold stock buy it at different prices over time, so they need a consistent rule for deciding which cost to attach to each unit sold. FIFO answers by saying the earliest costs go first.
The unit cost of the oldest batch is charged against revenue before any newer batch is touched. The result is a closing inventory made up of the latest purchases, which means the balance sheet figure is close to current replacement cost.
That is a real advantage, because inventory is shown at a realistic amount. The income statement, however, carries older costs, which may not match today's prices.
When prices are rising, FIFO reports lower cost of goods sold and higher gross profit than LIFO (last in, first out), which charges the newest costs first. When prices are falling, the effect is reversed.
The cash position is identical under both methods apart from tax effects, so the difference is purely one of accounting timing. The choice matters for tax and for comparisons.
In jurisdictions where LIFO is allowed, a company using it may report lower profit and pay less tax in an inflationary period. International standards do not allow LIFO, so many global groups use FIFO or weighted average cost, which blends all purchases into an average.
Perpetual inventory systems keep a running record of layers of stock, each with its own cost, and apply FIFO automatically as sales are processed. Periodic systems work out the same answer at the end of a period, using a count of what remains.
Both approaches should give the same result under FIFO. FIFO has one more benefit in practice, which is that it is easy to explain to non-accountants.
A manager can picture the oldest stock being sold first and follow the numbers without a long technical briefing. That clarity helps when finance explains margins to sales teams or to lenders.
In practice
Real-world examples
Example 1
An electronics retailer buys phone cases in three shipments with rising prices. Under FIFO the earliest and cheapest shipment is expensed first, so reported gross margin looks healthy during the price increase. Management should watch for margin squeezes when the low-cost older stock runs out.
Example 2
A food wholesaler uses FIFO both physically and in its books, rotating pallets so the oldest dated product ships first. The accounting method matches the warehouse practice and keeps waste low. Where the physical and accounting flows are the same, the stock records are easier to audit.
Example 3
A manufacturer is acquired by a group that reports under international standards. Because LIFO is not permitted, the company must restate its inventory using FIFO and recognises a one-off adjustment. The group's accountants explain the change to the lenders before the new figures are published.
Think of it
Imagine a queue at a popular bakery. The person who arrived first is served first, and the person who arrived last waits at the back. FIFO works the same way for your stock.
Formula
Calculation
Cost of goods sold = Units sold taken from the oldest layers, each at its own unit cost
Ending inventory = Units remaining, valued at the most recent unit costs
Orchard Supply, a fictional distributor, buys 200 units at $5 in January and 300 units at $6 in February, then sells 350 units. Under FIFO, cost of goods sold is the 200 units at $5 plus 150 units at $6, which is $1,000 + $900 = $1,900. The ending inventory is the remaining 150 units at $6, which is $900. Under LIFO the 300 units at $6 and 50 units at $5 would go first, giving cost of goods sold of $1,800 + $250 = $2,050, which is $150 higher than FIFO.Case study
Seen in the real world
Birchwood Bikes is an illustrative, fictional retailer that imports frames from overseas. During a year of rising freight and material costs, the owner noticed that the profit reported to the bank was higher than the cash the business was generating.
The accountant showed that under FIFO the older, cheaper frames were being sold first, so profit included a gain from buying early. Replacing the sold frames cost more, and cash was being absorbed by restocking.
In the illustrative response, Birchwood kept FIFO for reporting but added a cash-based restocking forecast to its monthly pack. The owner then priced new stock using replacement cost rather than the older book cost, which protected margins in a rising market. Birchwood's owner now reviews margin on a replacement cost basis each quarter to make sure the picture is not flattered by older costs.
Watch out
Common mistakes
- Confusing the physical flow of goods with the accounting cost flow, when FIFO is an assumption that need not match what is on the shelf.
- Assuming FIFO and LIFO give the same profit, when they differ whenever purchase prices change.
- Forgetting that under FIFO the closing inventory reflects the newest costs, not the oldest.
Questions
People also ask
Why do companies prefer FIFO?
It is simple, accepted internationally and values inventory close to current cost, though it can raise taxable profit when prices are rising.
How does FIFO affect the balance sheet?
It shows inventory at the most recent purchase costs, so the balance sheet value is close to replacement cost.
What is the difference between FIFO and weighted average cost?
FIFO uses actual layers of cost in order, while weighted average blends all purchase costs into a single average price.