First-in, first-out (FIFO) is a popular and GAAP-approved accounting method that companies use to calculate and value their inventory—which, of course, ultimately impacts their earnings. FIFO has several strong points. But it also has drawbacks, most of them related to inflation. Let's look at the disadvantages of FIFO, and compare it to its accounting-method opposite, LIFO.
- While it has several advantages, the first-in, first-out (FIFO) accounting method has several drawbacks.
- In times of inflation, FIFO will show increased profits—though these may only be on paper.
- The inflated earnings that FIFO tends to show can result in a heavier tax burden for companies.
- The contrary accounting method last-in, first-out (LIFO) creates higher costs and lowers net income, which also reduces taxable income.
How FIFO Works
First, a quick recap. In the manufacturing world, first-in, first-out (FIFO) is an inventory management/valuation system used during an accounting period to assign costs to a company's goods (including raw materials, goods that are in production, and finished goods that ready for sale).
As its name implies, FIFO assumes the first inventory manufactured or purchased during a period is sold first, while the inventory manufactured or produced last is sold last. It's kind of like milk in a grocery store. The milk the store buys first is pushed to the front of the shelf and sold first. Milk that purchased later gets buried in the back and is not sold until the older milk is gone.
Therefore, inventory purchased early in the period gets assigned to the cost of goods sold (COGS), and inventory purchased last, usually unsold, gets assigned to ending inventory.
Example of FIFO
Here's a simple example of how FIFO works in accounting terms. Say Sunshine Bakery produces 500 corn muffins on Monday at a cost of $1 each, and 500 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 500 muffins (half its inventory) on Wednesday, the COGS (on the income statement) is $1 per muffin because that was the cost of each of the first muffins that it baked and had in stock. The $1.25 muffins would be allocated to ending inventory (on the balance sheet).
Advantages of FIFO
FIFO has several advantages as an accounting system. Among them:
- It's easy to understand and use—in fact, it's one of the most widely applied accounting methods out there, both in the U.S. and abroad.
- It makes it difficult to manipulate figures and income—the cost attached to the unit sold is always the oldest cost.
- It aligns the expected cost flow with the logical, physical flow of goods (in our example, we sold our older muffins first, remember), offering businesses a truer picture of inventory costs.
- It's a better indicator of the worth of the ending inventory—the balance sheet amount is likely to approximate the current market value.
Disadvantages of FIFO
Of course, no method is perfect. Strong as it is, FIFO has its drawbacks—especially in times of dramatic inflation or a prolonged inflationary period.
In a rising-price environment, companies using the FIFO method to report COGS that do not reflect what the production and materials actually cost at the time the financial statements are being calculated and released. Instead, lower costs are assigned to the goods sold, leaving the newer, more expensive inventory on the balance sheet. As a result, FIFO can increase net income and inflate profits, because inventory that might be several years old, which was acquired or produced for a lower cost is used to value your expenses.
To put it bluntly, FIFO often makes it look, at least on paper, that companies are making more money than they actually are. This larger-than-life profit, of course, leads to a heavier tax burden—report more earnings on the tax return, and the IRS naturally wants a bigger cut.
FIFO is especially vulnerable during periods of hyperinflation: It typically fails to show an accurate picture of costs when material prices increase rapidly and/or excessively. In this sort of situation, the matching of the oldest inventory with the most recent sales would not be appropriate and may pump up profits to present a distorted picture. The same thing can happen in periods where prices are fluctuating greatly.
FIFO vs. LIFO
One alternative accounting method to FIFO is LIFO (last-in, first-out). As the name implies, this approach is the opposite of FIFO: The LIFO method assumes goods manufactured or purchased last during a period are the first sold. So, under LIFO, the most recent products are the first to be expensed as cost of goods sold (COGS), which means the lower cost of older products will be reported as ending inventory.
Companies doing business globally should know that LIFO—while accepted under GAAP—is not a method allowed by International Financial Reporting Standards (IFRS) and other accounting systems used around the world.
FIFO's weaknesses are LIFO's strengths, and vice-versa. During periods of inflation, LIFO shows the largest cost of goods sold because the newest costs charged to COGS are also the highest costs. The larger the cost of goods sold, the smaller the net income—and the smaller the tax liability. Along with it lowering taxable income, LIFO supporters argue that its use also leads to a better matching of costs and revenues: The income statement reports both sales revenue and the cost of goods sold in current dollars.
On the downside, LIFO is more difficult to maintain than FIFO because it can result in older inventory never being shipped or sold—not great for perishable goods—or at least, not being recorded as such in the accounting system. LIFO can grossly misstate inventory, and permit income manipulation, as well.
The Bottom Line
The first-in, first-out (FIFO) accounting method has two key disadvantages. It tends to overstate gross margin, particularly during periods of high inflation, which creates misleading financial statements. Costs seem lower than they actually are, and gains seem higher than they actually are.
Unfortunately, these high paper profits created by FIFO accounting have a real, material consequence: They can cause a company to incur substantially higher income taxes.