First in First Out (FIFO)
What is First in First Out (FIFO) all about? It’s a valuation and asset-management method where assets that have been produced or acquired first are disposed of, sold, or used first.
In other words, it’s an inventory costing system to help managers track the cost of stock that’s been sold. It assumes that the first product purchased is the first product sold—in essence, the first in the door is the first out of the door. Makes sense, right?
Manufacturing companies and retailers rely on their inventories to track what’s bought and what’s sold. Although this sounds simple enough, if a company has a large amount of stock, it needs a sophisticated inventory tracking system. Otherwise, how will they know what’s sold? That’s why companies like using FIFO—it makes life simpler.
Example of FIFO
Here’s an example: A retailer sells jewelry. They know they bought 100 necklaces in June and 200 in July. If they sold 175 necklaces during the year, do they know immediately which necklaces they sold? Was it the ones bought in June or the ones in July? They use FIFO to assume that the 100 necklaces bought in June were the first ones sold because they were the first ones bought.
Continuing with the necklace scenario, if the 100 necklaces purchased in June cost $1 each and the ones in July cost $1.50 each, if a total of 175 were sold that year, FIFO would report the cost at $100. It doesn’t take into account that the ones purchased in July cost more.
So, using this FIFO method, the reality is that a company will report lower costs of goods sold on its income statement and its tax return than it actually incurred for that year. It’s a way for a company’s management to increase reported probability. The downside is that higher reported profits and lower costs = more taxable income.