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First In First Out Method (FIFO)

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January 18th, 2024
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First In First Out Method (FIFO)

Definition

The financial accounting term first-in, first-out refers to one of several approaches to inventory valuation. The first-in, first-out method assumes the oldest items held in inventory are the first items to be sold when determining the value of inventory appearing on a company's balance sheet.

Explanation

Also referred to as FIFO, the first-in, first-out method assumes the oldest items held in stock are the first items to be sold. This is an assumption used to value inventory; the physical flow of items from inventory may differ from this valuation technique.

When the cost of materials is rising, the FIFO method will assign a larger dollar value to ending inventory than under an average cost method. Since the items remaining in inventory at year end are assigned "recent" cost, this approach is viewed as one of the more "realistic" methods to valuing inventory.

Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. It's also important to understand the ending inventory value for one year is likewise the beginning inventory value in the following year. Inventory errors also have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.

Example

The following table illustrates the FIFO approach to valuing inventory. Company A begins the year with 250 units, adds 400 units throughout the year, and sells 500 units. The ending inventory for Company A is 150 units.

Units

Cost per Unit

Total Cost

Beginning Inventory

250

$700

$175,000

Additions on March 1

100

$725

$72,500

Additions on June 1

100

$750

$75,000

Additions on September 1

100

$775

$77,500

Additions on December 1

100

$800

$80,000

Cost of Goods Available for Sale

650

$480,000

Units Sold

500

Additions on September 1

50

$775

$38,750

Additions on December 1

100

$800

$80,000

Ending Inventory

150

$118,750

The above ending inventory of $118,750 can be used along with the cost of goods available for sale ($480,000) to determine the Cost of Goods Sold:

= Cost of Goods Available for Sale - Ending Inventory = $480,000 - $118,750, or $361,250

Related Terms

  • Inventory
    The financial accounting term inventory is used to describe the balance sheet line item that includes the value of raw materials, work in process, finished goods ready for sale, and returned goods that can be resold.
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  • Balance Sheet
    Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
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  • The financial accounting term net Income is used to describe a measure of a company's profitability. Net income is a line item appearing on the income statement, and is derived by subtracting expenses from revenues.
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  • Cost of Goods Sold (COGS)
    The direct expense a company incurs when making a product, or supplying a service, such as raw materials and labor are referred to as the cost of goods sold (COGS). Also referred to as the cost of sales, the cost of goods sold appears as a line item expense on the income statement.
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  • Last In First Out Method (LIFO)
    The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.
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  • Gross Profit Method
    The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.
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  • Lower of Cost or Market
    The financial accounting term lower of cost or market refers to an inventory valuation rule that states items should be valued at their original cost or their current market cost, whichever is lower.
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