If you’re studying to pass the CPA Exam or a college- or university-level accounting class, you’ll be required to have a fairly in-depth understanding of FIFO. We’re here to explain the FIFO method, and if you have further questions, leave a comment below!
A cost flow assumption refers to how a company assigns costs to its inventory. These assumptions are theoretical and often don’t reflect how goods actually flow. That’s why it’s referred to as an assumption. Under U.S. Generally Accepted Accounting Principles (GAAP), the most common assumptions that are used to determine the cost flow factors include:
It is practically impossible for most companies to track the flow of each and every inventory item. So, the company’s management is responsible for determining the best cost flow assumption. The assumption is certainly a subjective matter, and the definition of “best” will depend on the business type.
The FIFO inventory cost flow provides the best depiction of the actual flow of goods compared to other cost flow assumptions. Suppose you’re in the grocery store’s bulk section, and you want to dispense some chocolate covered almonds from the dispenser (yum!). As you dispense the almonds, do you think you’re getting the oldest or the newest almonds? The answer to that: you’re getting the oldest ones. When the grocery store stock person puts the almonds in, the container is filled to the rim. Then, as people like you purchase almonds, the stock person continues to fill the dispenser’s top with newer almonds. So, the grocery store disperses the oldest almonds first. This example shows exactly how FIFO inventory works!
Grocery stores want to sell their oldest inventory first, so it doesn’t spoil or expire. The grocery store’s approach reflects the FIFO inventory method, which assumes that the store sells its oldest inventory items first. That means that you’ll use the oldest costs to calculate the cost of goods sold.
There are two common and contrasting accounting methods that can track the cost of goods sold and ending inventory. Those are the periodic inventory system and the perpetual inventory system. The formula to calculate the cost of goods sold for a period under a periodic inventory system is:
Beginning Inventory $XXX,XXX
+ Purchases $XXX,XXX
Goods Available for Sale $XXX,XXX
– Ending Inventory (From Physical Count) ($XXX,XXX)
Cost of Goods Sold $XXX,XXX
But, what if you knew the cost of goods sold and wanted to calculate ending inventory instead? You can change up the order of this equation to do this. Ending inventory is equal to goods available for sale minus the cost of goods sold. If a physical ending inventory count hasn’t happened yet, a company will use this formula to compute the ending inventory balance.
Let’s look at an example. Pinky’s Popsicles just opened their first popsicle stand, and they bought 2 batches of inventory during the year. Batch 1 was for 1,000 units at $0.75 per unit. Batch 2 was for 2,750 units at $0.90 per unit. Pinky’s sold 2,000 units in total. For clarity, Pinky’s sold 775 units after the first purchase, and 1,225 units after the second purchase. To calculate ending inventory and COGS using FIFO in a periodic inventory system, start by calculating goods available for sale:
Beginning Inventory $0
+ Batch 1 Purchases (1,000 units @ $0.75 each) $750
+ Batch 2 Purchases (2,750 units @ $0.90 each) $2,475
Goods Available for Sale $3,225
In this case, we don’t know the value of ending inventory. But, we do know the cost of goods sold. So, you can use COGS to “squeeze” out this value. Under FIFO, you need to account for selling your oldest inventory first. In the case of Pinky’s Popsicles, Batch 1 is the oldest. That means we should use up all of Batch 1 before Batch 2 when determining COGS. If any remains, it will come from Batch 2. Pinky’s sold 2,000 units in total. Therefore, in a periodic system that uses FIFO, you can solve for the cost of goods sold as:
COGS from Batch 1 (1,000 units @ $0.75 each) $750
COGS from Batch 2 (1,000 units @ $0.90 each) $900
Total Cost of Goods Sold $1,650
After you calculate the total COGS, you can compute FIFO ending inventory by using this formula:
Goods Available for Sale $3,225
– COGS ($1,650)
Ending Inventory $1,575
The key takeaway here is that when you’re calculating the cost of goods sold or ending inventory using periodic FIFO, the date on which the company sold the goods doesn’t matter. You simply assume that the oldest stock is sold first and apply this assumption to your calculations.
When a company uses a perpetual inventory system, the inventory record is updated perpetually (as the name implies!). Consequently, each time inventory is purchased or sold, the company updates its inventory record. And the inventory record allows you to determine the actual cost of goods sold for each sale.
Using the same example for Pinky’s Popsicles, you can easily calculate COGS and ending inventory using this table. It breaks down each transaction so you can see and understand precisely how Pinky’s perpetually tracks the inventory.
|Units Purchased||Units Sold||Cost per Unit||Change in Inventory||Balance in Inventory||COGS|
|1,225||$0.75 (225 units)
$0.90 (1,000 units)
|Total Ending Inventory (equal to ending balance in inventory)||$1,575|
Based on the examples shown above, Pinky’s Popsicles ending inventory and cost of goods sold is the same – regardless of the method used! Utilizing the FIFO assumption, you can see that if prices are rising, the FIFO method will result in the highest ending inventory compared to other inventory cost flow assumptions. In our Pinky’s Popsicles example, the prices were rising because Batch 1 was purchased for $0.75 per unit, whereas Batch 2 cost $0.90 per unit. Because the prices for goods are increasing, Pinky’s is selling their cheaper inventory items first. So, they will have the more expensive inventory items on the books as ending inventory at year-end.
On the flip side, if prices fall during the year, FIFO will have the lowest ending inventory and the highest cost of goods sold.
So, now that you understand that the cost flow assumption used impacts the COGS and Ending Inventory, you may be wondering what else it affects. It definitely doesn’t end there! FIFO has the highest gross profit during periods of rising prices. Let’s look at an example of transactions for Harry’s Hamburgers to illustrate this:
You can calculate that the cost of goods sold would equal $8,500 using FIFO accounting
So, if the revenue on the sale was $20,000, gross profit would be: $20,000 – $6,500 = $13,500
Now, what if it were a time of falling prices? Let’s look at how that might change the impact on gross profit.
The cost of goods sold would now be $6,625, which is more expensive than it was during the period of rising prices.
Lastly, gross profit FIFO would be $20,000 – $6,625 = $13,375. Therefore, gross profit was $125 higher during periods of rising prices vs. periods of falling prices.
In some cases, a company may decide that they want to switch from FIFO to LIFO. This change can create some pretty significant impacts on its financial and income statement accounts. Because of this change’s significance, a company that makes this switch will need to restate its prior period financial statements to show the resulting changes. As a financial statement user, you would want to compare a company’s performance year over year. Without this requirement to restate financials, if there is a change, you wouldn’t be able to analyze a company’s performance because the numbers would be all over the place!
Suppose it’s impossible or impractical for a company to understand the impact of switching from FIFO to LIFO. In that case, they need to include a disclosure in their current period financials and apply this method to periods moving forward.
As we discussed above, FIFO results in a higher gross profit during periods of rising prices. But, this means it will also result in a higher income tax expense! However, if a company used LIFO during a period of rising prices, gross profit would be lower. That means that income tax expense would also be lower.
The FIFO reserve, often called the LIFO reserve, keeps track of differences in accounting for inventory when a company utilizes a FIFO method or LIFO method. Sometimes, companies will opt to use FIFO internally because it shows the physical flow of goods. But, they will use LIFO for financial reporting purposes because it typically offers a lower income tax expense. The FIFO or LIFO reserve is the difference between LIFO inventory and FIFO inventory.
I am the author of How to Pass The CPA Exam (published by Wiley), and I also passed all 4 sections of the CPA Exam on my first try. Additionally, I have led webinars, such as for the Institute of Management Accountants, authored featured articles on websites like Going Concern and AccountingWeb, and I'm also the CFO for the charity New Sight. Finally, I have created other accounting certification websites to help mentor non-CPA candidates. I have already mentored thousands of CPA, CMA, CIA, EA, and CFA candidates, and I can help you too!
Perpetual Inventory Systems