FIFO is one of several ways to calculate the cost of inventory in a business. The other common inventory calculation methods are LIFO (last-in, first-out) and average cost.
FIFO, which stands for "first-in, first-out," is an inventory costing method that assumes that the first items placed in inventory are the first sold. Thus, the inventory at the end of a year consists of the goods most recently placed in inventory.
Why Value Inventory?
One reason for valuing inventory is to determine its value for inventory financing purposes. Another reason for valuing inventory is that inventory costs are included in the cost of goods sold, which reduces business income for tax purposes.
Inventory Costing Explained
The calculation of inventory cost is an important part of filing your business tax return. Like other legitimate business costs, the cost of the products you buy to resell can be deducted from your business income to reduce your taxes.
At the beginning of the year, you have an initial inventory of products in various stages of completion or ready to be sold. During the year, you buy more inventory and sell some of the inventory. At the end of the year, you want to record the cost of the inventory you've sold, as an expense of doing business, which is deducted from your sales. This calculation is called the cost of goods sold.
The IRS has set up some possible ways you can calculate the cost of goods sold. FIFO is one method used to determine the cost of inventory sold for your business tax return.
Calculating Inventory Cost Using FIFO
Here is how inventory cost is calculated using the FIFO method:
Assume a product is made in three batches during the year. The costs and quantity of each batch are:
- Batch 1: Quantity 2,000 pieces, Cost to produce $8000
- Batch 2: Quantity 1,500 pieces, Cost to produce $7000
- Batch 3: Quantity 1,700 pieces, Cost to produce $7700
- Total produced: 5,200 pieces. Total cost $22,700. Average cost to produce one piece: $4.37.
Next, you must calculate the unit costs for each batch produced.
- Batch 1: $8000/2000 = $4
- Batch 2: $7000/1500 = $4.67
- Batch 3: $7700/1700 = $4.53
Let's say you sold 4,000 units during the year, out of the 5,200 produced. You don't know which pieces at which cost were sold. To determine the cost of units sold, under FIFO accounting, you start with the assumption that you have sold the oldest (first-in) produced items first.
So, of the 4,000 units sold, using FIFO:
- You assume that all 2,000 of the Batch 1 items worth $4 each were sold first. The first 2,000 units sold from Batch 1 cost $4.00 per unit. That's a total of $8,000.
- The next 1,500 units sold from Batch 2 cost $4.67 per unit, for a total of $7,005.
- And the last 500 units sold from Batch 3 cost $4.53 each, for a total of $2,265.
- Adding these costs together, the total cost of the 4,000 items sold is $17,270.
This calculation is not exactly what happened because in this type of situation it's impossible to determine which items from which batch were sold in which order. It's just a way to get a calculation.
Other Costing Methods
Instead of using FIFO, some businesses use one of these other inventory costing methods:
- Specific identification is used when specific items can be identified. For example, the cost of antiques or collectibles, fine jewelry, or furs can be determined individually, usually through appraisals.
- LIFO costing ("last-in, first-out") considers the last produced products as being those sold first. In this case, you would assume that Batch 3 items would be sold first, then Batch 2 items, then the remaining 800 items from Batch 1 would be sold. The total cost of 4000 items sold under LIFO accounting would be $17,906.
LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher. However, in times of falling prices, the opposite will hold.
FIFO is the default method of determining inventory value. If you want to use LIFO, you must meet some specific requirements and file an application using IRS Form 970.