What is 'First In, First Out - FIFO'
First in, first out (FIFO) is an asset-management and valuation method in which the assets produced or acquired first are sold, used or disposed of first and may be used by a individual or a corporation. For taxation purposes, FIFO assumes that the assets that are remaining in inventory are matched to the assets that are most recently purchased or produced.
BREAKING DOWN 'First In, First Out - FIFO'
FIFO is used for cost flow assumption purposes. As items being manufactured progress to later development stages and as finished inventory items get sold, the associated costs with that product must be recognized as an expense. The dollar value of total inventory decreases as this occurs because inventory has been removed from the company’s ownership. The costs associated with the inventory may be calculated in numerous ways — one being the FIFO method.
As inventory items are prepared for sale, they are assigned costs. This may occur through the purchase of the inventory of production costs through the purchase of materials and utilization of labor. These assigned costs are based on the order in which the product was used, and for FIFO, it is based on what arrived first. For example, if 100 items were purchased for $10 and 100 more items were purchased the next for $15, FIFO would assign the cost of the first item resold of $10. After 100 items were sold, the new cost of the item would become $15, regardless of any additional inventory purchases made.
The FIFO method follows the logic that to avoid obsolescence, a company would sell the oldest inventory items first and maintain the newest items in inventory. Although the actual inventory valuation method used does not need to follow the actual flow of inventory through a company, an entity must be able to support why it selected the use of a particular inventory valuation method.
Impact of FIFO vs. Other Valuation Methods
Typical economic situations involve inflationary markets and rising prices. In this situation, if FIFO assigns the oldest costs to cost of goods sold, these oldest costs will be theoretically be priced lower than the most recent inventory purchased (at current inflated prices). This lower expense results in higher net income. In addition, because the newest inventory was purchased at generally higher prices, the ending inventory balance is inflated.
Alternatives to FIFO
The inventory valuation method opposite to FIFO is LIFO, where the last item in is the first item out. In inflationary economies, this results in deflated net income costs and lower ending balances in inventory when compared to FIFO. The average cost inventory method assigns the same cost to each item. This results in net income and ending inventory balances between FIFO and LIFO. Finally, specific inventory tracing is used when all components attributable to a finished product are known. If all pieces are not, the use of any method out of FIFO, LIFO, or average cost is appropriate.