Applying Inventory Costing Methods: FIFO

TL;DR

FIFO (First-In, First-Out) assumes that the first inventory items you buy are the first ones you sell, directly impacting your Cost of Goods Sold (COGS) and ending inventory. This method mirrors the physical flow of most businesses, especially for perishable goods or products with limited shelf life. Understanding FIFO is crucial for accurately reporting profit and inventory value on your financial statements.

1. The Mental Model

Think of your inventory like a stack of fresh groceries at a supermarket: the oldest items (at the front) are sold first to ensure freshness, and newer items are placed behind them.

2. The Core Material

FIFO is an inventory costing method that assumes the first units purchased are the first ones sold. This means that when you make a sale, the cost assigned to that sale (Cost of Goods Sold or COGS) comes from the cost of the earliest inventory units available. Consequently, your ending inventory is valued based on the cost of the most recent purchases.

This method is popular because it often aligns with the actual physical flow of inventory for many businesses, especially those dealing with:
* Perishable goods (food, flowers)
* Fashion items (seasonal clothing)
* Products with expiration dates (medication)

How FIFO Impacts Financial Statements:

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• Cost of Goods Sold (COGS): When prices are rising, FIFO results in a lower COGS because it matches older, cheaper costs with sales. When prices are falling, FIFO results in a higher COGS.
• Ending Inventory: When prices are rising, FIFO results in a higher ending inventory value because it leaves the newer, more expensive items in stock. When prices are falling, FIFO results in a lower ending inventory value.
• Gross Profit: Since COGS is lower (with rising prices), gross profit will be higher under FIFO.
• Income Tax: Higher gross profit means higher net income, which can lead to higher income tax payable.

Calculating COGS and Ending Inventory with FIFO:

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To calculate COGS and ending inventory using FIFO, you essentially track your purchases and sales chronologically.

Here's a simple process flow for applying FIFO:

graph TD
    A["Start: Track Inventory"] --> B{"Is it a Sale?"}
    B -- Yes --> C["Identify units sold"]
    C --> D["Assign cost of OLDEST available units to COGS"]
    D --> E["Update remaining inventory (remove sold units)"]
    E --> F{"Are there more sales or purchases?"}
    F -- Yes --> B
    B -- No --> G{"Is it a Purchase?"}
    G -- Yes --> H["Add new units to inventory at their cost"]
    H --> F
    G -- No --> I["End: Calculate Ending Inventory Value"]
    I --> J["Ending Inventory = Cost of MOST RECENT available units"]

3. Worked Example

Let's say "Gadget Co." has the following inventory activities for the month of January:

• Jan 1: Beginning Inventory: 100 units @ \$10 each
• Jan 5: Purchase: 200 units @ \$12 each
• Jan 15: Sale: 150 units
• Jan 20: Purchase: 150 units @ \$13 each
• Jan 25: Sale: 200 units

We need to calculate the Cost of Goods Sold (COGS) for January and the value of the Ending Inventory.

Step-by-Step FIFO Calculation:

1. Beginning Inventory (Jan 1):

   • 100 units @ \$10 = \$1,000

2. Purchase (Jan 5):

   • Inventory now:
     • 100 units @ \$10
     • 200 units @ \$12

3. Sale (Jan 15): 150 units sold

   • Under FIFO, we sell the oldest units first.
   • From Jan 1 inventory: 100 units @ \$10 = \$1,000
   • Remaining to sell: 150 - 100 = 50 units
   • From Jan 5 purchase: 50 units @ \$12 = \$600
   • COGS for Jan 15 sale = \$1,000 + \$600 = \$1,600
   • Inventory remaining:
     • (200 - 50) = 150 units @ \$12

4. Purchase (Jan 20):

   • Inventory now:
     • 150 units @ \$12
     • 150 units @ \$13

5. Sale (Jan 25): 200 units sold

   • Again, sell the oldest units first.
   • From remaining Jan 5 purchase: 150 units @ \$12 = \$1,800
   • Remaining to sell: 200 - 150 = 50 units
   • From Jan 20 purchase: 50 units @ \$13 = \$650
   • COGS for Jan 25 sale = \$1,800 + \$650 = \$2,450
   • Inventory remaining:
     • (150 - 50) = 100 units @ \$13

Summary for January:

• Total COGS: \$1,600 (Jan 15) + \$2,450 (Jan 25) = \$4,050
• Ending Inventory (Jan 31): The remaining units are the newest ones.
  • 100 units @ \$13 = **\$1,300**

4. Key Takeaways

• FIFO assumes the oldest inventory items are sold first, matching their cost to the Cost of Goods Sold.
• This method generally reflects the physical flow of most businesses, especially those with perishable goods.
• When prices are rising, FIFO results in a lower COGS, a higher gross profit, and a higher ending inventory value.
• When prices are falling, FIFO results in a higher COGS, a lower gross profit, and a lower ending inventory value.
• FIFO presents a balance sheet inventory value that is closest to current replacement cost during inflation.
• It's an important choice for external reporting as it impacts reported profitability and asset value.
• The company must choose an inventory costing method and apply it consistently unless there's a strong reason to change.

Common Mistakes to Avoid:
- Mixing up units: Don't accidentally apply the cost of newer units to older sales or vice versa. Always go strictly by the order of purchase.
- Incorrectly calculating remaining units: After a sale, ensure you subtract the correct number of units from the correct cost layer.
- Forgetting to update inventory layers: Each purchase adds a new layer, and each sale depletes from the oldest available layers.
- Not considering the impact of price changes: Understand that FIFO's impact on COGS and ending inventory flips depending on whether prices are rising or falling.

5. Now Try It

You're managing inventory for "Book Nook," selling collectible books. Here are the transactions for February:

• Feb 1: Beginning Inventory: 50 books @ \$25 each
• Feb 8: Purchase: 80 books @ \$30 each
• Feb 14: Sale: 70 books
• Feb 20: Purchase: 60 books @ \