What Is FIFO?
First in, first out (FIFO) is an accounting method for inventory valuation. It assumes that goods are sold and/or used in the same chronological order in which they are acquired.
In simpler words, the FIFO method assumes that merchandise purchased first is sold first.
Understanding the First in, First out Method
FIFO values all inventory according to the cost of the earliest-purchased merchandise within a given accounting period. FIFO does not recognize the disparity between the costs of earlier- (or later-) purchased merchandise. As a result, revenues from sold merchandise are measured against the cost of the earliest-purchased merchandise – regardless of any differences in the cost of the merchandise or of the goods themselves.
Suppose that at the beginning of a given period, Store XYZ buys 10 coffee mugs at a cost of one dollar each. A week later, the store also buys picture frames for $5 each.
At the end of the period, the store has sold 10 total items (a combination of coffee mugs and picture frames) for $100 in revenue. Although not all of the 10 items sold were coffee mugs, the revenue that the store received from sales will only be measured against the cost of the 10 coffee mugs ($10). That’s because, as inventory, they were acquired first.
Why Is FIFO Important?
Because inventory can make up a substantial portion of a company's assets (and is an important component of the balance sheet), it is crucial for investors to take the time to understand how inventory is valued.
Though there are tax advantages to using FIFO in the case of higher first-in inventory costs, FIFO can result in higher taxes in the event of inflation (especially when combined with the sale of more recently-purchased items).