FIFO Method of Inventory Valuation
The First In, First Out (FIFO) method of inventory valuation assumes the earliest goods you purchase are the ones you sell first — first in, first out. Imagine that your business buys and sells folding chairs. On January 1, you purchase 250 chairs for $10 each. On January 4, you purchase another 200 chairs of the exact make for $8 each. On January 7, you sell 50 chairs.
Under the FIFO method, you sold goods that were among the first to be purchased. In this case, the cost of the 50 chairs you sold is $10 per chair, since the earliest chairs you bought cost $10 each. The remaining 200 chairs at $10 each and 200 chairs bought at $8 each go on your balance sheet as inventory.
This inventory method is most beneficial for a small business during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest. Imagine you buy an item of inventory for $25. Six months later, you buy the same piece of inventory for $35. When one of the items is eventually sold for $50, the FIFO method dictates the cost of the good sold is $25. Therefore, the FIFO method is most advantageous when attempting to maximize net income.
Another advantage of the FIFO method is that it conceptually avoids obsolescence. Because you sell older inventory items first, inventory listings have a lower chance of reporting items too old to sell.
However, there are drawbacks to the FIFO method. Income taxes are higher, and your company needs more cash to pay that bill. In addition, with FIFO, current period costs aren’t reported in the current period. This makes the financial statements slightly inaccurate. In the second example above, although you pay $35 for your product in the current period, the actual expense recognized is only $25. Therefore, you must manage cash flows more actively.