First in, first out (FIFO) accounting is an inventory accounting method that assumes the first goods that enter your inventory are the first goods to leave it. As prices fluctuate, this method gives you a consistent framework for determining the cost of both the goods you sell and the goods you still have on hand.
Basics of FIFO Accounting
When you buy or manufacture inventory, the costs to do so don’t always remain steady. If you manufacture your own goods, the costs of your raw materials might increase, which makes your costs higher. Under FIFO, when you make a sale, you assign a cost of goods sold to that sale based on the oldest items in your inventory. You then consider those older items to no longer be part of the inventory, and the costs of the newest products become the basis for your inventory valuation.
This does not require you to track each individual item you sell to determine its actual age. Instead, this method saves time by allowing you to simply assume it’s the oldest item in your inventory each time. One disadvantage of FIFO accounting is it often leads to overstated gross margin during inflation when the cost of the older inventory tends to be lower than the cost of the newer inventory.
FIFO Accounting in Action
Assume you have a small business that sells lamps. In your inventory, you have a lamp you bought six months ago for $10 and an identical lamp you bought a day ago for $15. When a customer buys a lamp from you for $30, FIFO accounting assumes the customer buys the lamp you bought six months ago. Your gross margin of selling the lamp is $30 – $10 = $20, regardless of which lamp they actually bought. You remove the $10 valuation from your books, so your current inventory amount is $15.
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