FIFO Inventory Method

By Yuriy Smirnov Ph.D.

Definition

The first-in, first-out or FIFO inventory method is used to compute the cost of goods sold (COGS) and the inventory account balance at the end of the relevant period. The idea behind this method is that inventories bought first should be sold first. In other words, inventories have to be assigned to cost of goods sold in the order they entered the stock.

Let’s imagine that each batch is a separate layer as shown in the figures below.

The beginning inventory of 195 units is composed of 4 batches shown in the order they arrived (Batch 1 is the oldest one).

After some time, 80 units were sold (Figure 2). The cost of Batch 1 and the cost of 30 units of Batch 2 should be assigned to the cost of goods sold. In turn, the balance of the inventory account amounts to the cost of 30 units of Batch 2, the cost of Batch 3, and the cost of Batch 4.

Let’s assume that a company has bought 55 units to replenish stock (Figure 3). Thus, the ending inventory is 170 units.

Examples

XYZ Ltd has made the following transactions during the first quarter:

Let’s calculate the inventory balance on 31st of March and cost of goods sold (COGS) using the FIFO inventory method.

FIFO Periodic

Let’s assume that the company uses a periodic inventory system. Under that system, the ending inventory is calculated as the sum of the beginning inventory and total purchases during the relevant period less units sold.

Total purchases = 75,000 + 90,000 + 60,000 = 225,000 units

Units sold = 23,000 + 27,000 + 35,000 + 65,000 + 35,000 + 42,000 = 227,000 units

Ending Inventory = 45,000 + 225,000 – 227,000 = 43,000 units

The cost of goods sold equals the sum of each sale’s cost.

Cost of Jan 15 sale = 23,000 × $150 = $3,450,000

Cost of Jan 27 sale = 22,000 × $150 + 5,000 × $165 = $4,125,000

Cost of Feb 3 sale = 35,000 × $165 = $5,775,000

Cost of Feb 21 sale = 35,000 × $165 + 30,000 × $175 = $11,025,000

Cost of Mar 14 sale = 35,000 × $175 = $6,125,000

Cost of Mar 25 sale = 25,000 × $175 + 17,000 × $170 = $7,265,000

Thus, the cost of goods sold in the first quarter amounts to $37,765,000.

The ending inventory of 43,000 units is fully represented by the purchase made on 4th of March, so the ending balance of the inventory account is $7,310,000.

Ending Inventory = 43,000 × $170 = $7,310,000

FIFO Perpetual

If the FIFO perpetual inventory system is applied, the cost of goods sold and the balance of the inventory account are calculated after each transaction. This process can be described as follows:

Jan 1

Inventory Account Balance = 45,000 × $150 = $6,750,000

Jan 10

Inventory Account Balance = $6,750,000 + 75,000 × $165 = $19,125,000

Jan 15

COGS = 23,000 × $150 = $3,450,000

Inventory Account Balance = $19,125,000 – $3,450,000 = $15,675,000

Jan 27

COGS = 22,000 × $150 + 5,000 × $165 = $4,125,000

Inventory Account Balance = $15,675,000 – $4,125,000 = $11,550,000

Feb 3

COGS = 35,000 × $165 = $5,775,000

Inventory Account Balance = $11,550,000 – $5,775,000 = $5,775,000

Feb 12

Inventory Account Balance = $5,775,000 + 90,000 × $175 = $21,525,000

Feb 21

COGS = 35,000 × $165+30,000 × $175 = $11,025,000

Inventory Account Balance = $21,525,000 – $11,550,000 = $10,500,000

Mar 4

Inventory Account Balance = $10,500,000 + 60,000 × $170 = $20,700,000

Mar 14

COGS = 35,000 × $175 = $6,125,000

Inventory Account Balance = $20,700,000 – $6,125,000 = $14,575,000

Mar 25

COGS = 25,000 × $175 + 17,000 × $170 = $7,265,000

Inventory Account Balance = $14,575,000 – $7,265,000 = $7,310,000

Thus, the cost of goods sold totals $37,765,000, and the ending inventory account balance is $7,310,000.

Please note that both the periodic and perpetual FIFO inventory system give the same result!

FIFO Inventory Journal Entries

The journal entries to be made differ for the perpetual and periodic inventory system. Let’s assume that RetailPro Ltd has made the following transactions during June:

Perpetual Inventory System

If the perpetual inventory system is used, the inventory account and the cost of goods sold account are updated each time when a purchase or a sale is made.

Jun 1

Beginning inventory = 3,000 × $75 = $225,000

Jun 6

Sales = 1,600 × $100 = $160,000

COGS = 1,600 × $75 = $120,000

Inventory Account Balance = $225,000 – $120,000 = $105,000

Jun 9

Purchase = 4,500 × $80 = $360,000

Inventory Account Balance = $105,000 + $360,000 = $465,000

Jun 14

Sales = 2,300 × $110 = $253,000

COGS = 1,400 × $75 + 900 × $80 = $177,000

Inventory Account Balance = $465,000 – $177,000 = $288,000

Jun 23

Sales = 2,800 × $110 = $308,000

COGS = 2,800 × $80 = $224,000

Inventory Account Balance = $288,000 – $224,000 = $64,000

Jun 27

Purchase = 3,500 × $90 = $315,000

Inventory Account Balance = $64,000 + $315,000 = $379,000

Assuming that all purchases and sales are made on credit, journal entries to be made should look as follows:

Each sale of inventory requires two entries to be made in the journal. The first should record the sale value by debiting the accounts receivable account and crediting the sales account. The second should record the cost of goods sold by debiting the cost of goods sold account and crediting the inventories account.

Each purchase of inventory is recorded by debiting the inventory account and crediting the accounts payable account.

Periodic Inventory System

Under the periodic inventory system, purchases of inventory are recorded in the “Purchases” account, which is updated after each transaction, but the “Inventory” account is updated only once at the end of the accounting period. If all purchases and sales are made on credit, journal entries to be made should look as follows:

Each sale of inventory should be recorded in the journal by debiting the accounts receivable account and crediting the sales account. In turn, each purchase of inventory is recorded by debiting the purchases account and crediting the accounts payable account.

The periodic inventory system requires that a closing entry be made at the end of the accounting period. Since RetailPro Ltd is using the FIFO inventory method, the closing entry should look as follows:

Advantages and Disadvantages

Advantages of FIFO

The FIFO inventory method has the following advantages:

1. This method is recommended by many accounting standards, including the GAAP and IFRS, and is widely accepted by tax authorities.
2. Ending inventory better reflects the current market price because it is represented by the most recent batches.
3. It helps to reduce obsolete inventory write-off because the oldest batches are assigned to the cost of goods sold first.
4. It is easy to use and operate if a company does not have voluminous transactions.

Disadvantages of FIFO

The disadvantages of the FIFO inventory method are as follows:

1. The price of inventory can be affected to a great extent by inflation, especially if the inflation rate is high. Since the oldest batches with the lowest price are assigned to the cost of goods first, the cost of goods sold is understated. In other words, it is lower than inventories that would have been assigned by the current market price. The consequence of understated cost of goods sold is overstated gross profit because inventories are sold at their current market price. So, the company may have to pay higher taxes.
2. The matching principle requires sales and cost of goods sold to be matched and reported in the same accounting period. If inventories have slow turnover, the FIFO method is not a good choice.
3. If a company has a large number of transactions and the price of inventory fluctuates significantly, it can be difficult and cumbersome to manage inventories using the FIFO method.