Companies frequently use the first in, first out (FIFO) method to determine the cost of goods sold or COGS. The FIFO method assumes the first products a company acquires are also the first products it sells. The company will report the oldest costs on its income statement, whereas its current inventory will reflect the most recent costs. FIFO is a good method for calculating COGS in a business with fluctuating inventory costs.
While the LIFO inventory valuation method is accepted in the United States, it is considered controversial and prohibited by the International Financial Reporting Standards (IFRS).
Example of FIFO Method to Calculate Cost of Goods Sold
For example, John owns a hat store and orders all of his hats from the same vendor for $5 per unit. He has 100 units in his inventory at the beginning of August. In the middle of the month, his vendor raises the price per unit to $6. Over the month of August, John orders an additional 200 hats: 100 hats at $5 per unit and 100 hats at $6 per unit.
At the end of August, he has sold 250 hats. With FIFO, it is assumed that the $5 per unit hats remaining were sold first, followed by the $6 per unit hats. John's COGS for the month of August is $1,300. Because FIFO assumes all of the older inventory is sold first, John's remaining inventory is calculated using the most recently purchased price of $6 per unit, making his ending inventory cost $300 for the month of August.
While an actual sales pattern may not follow the FIFO cash flow assumption exactly, it is still an accurate method for determining COGS and allowed by both generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
Alternatives to FIFO for Determining Cost of Goods Sold
Last In, First Out (LIFO) Method
Last in, first out (LIFO) is another inventory costing method a company can use to value the cost of goods sold. This method is the opposite of FIFO. Instead of selling its oldest inventory first, companies that use the LIFO method sell its newest inventory first. Under this scenario, the last item in is the first item out.
For some companies, there are benefits to using the LIFO method for inventory costing. For example, those companies that sell goods that frequently increase in price might use LIFO to achieve a reduction in taxes owed.
Average Cost Method
The average cost method is another inventory costing method. With this method, companies add up the total cost of goods purchased or produced during a specified time. This amount is then divided by the number of items the company purchased or produced during that same period. This gives the company an average cost per item. To determine the cost of goods sold, the company then multiplies the number of items sold during the period by the average cost per item.
The simplicity of the average cost method is one of its main benefits. It takes less time and labor to implement an average cost method, thereby reducing company costs. The method works best for companies that sell large numbers of relatively similar products.