The first in, first out (FIFO) method is a cash flow assumption commonly used to determine cost of goods sold, or COGS. FIFO assumes that the first products acquired are also the first products sold, with the oldest cost being reported on the income statement so the current inventory reflects the most recent purchase prices. FIFO is a good method for calculating COGS in a business with fluctuating inventory costs.
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, but in the middle of the month, his vendor raises the price per unit to $6. Over the month of August, he 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 and international financial reporting standards.