Inventory cost accounting using the FIFO method.
The acronym FIFO stands for First In First Out.
I first came across this term when working in a supermarket as a teenager: when replenishing
stock, you need to make sure the oldest inventory is in the front and the newest inventory is
in the back, so the oldest inventory gets sold first and you avoid getting stuck with
obsolete inventory that has gone past the expiry date.
The next time I came across FIFO was when working as a junior cost accountant in manufacturing
finance at a plastics factory.
In that context, FIFO is an accounting fiction in cost accounting that is a major determinant
of Cost Of Goods Sold and Gross Profit.
Let’s work through an example of FIFO.
We will do the inventory accounting for a hypothetical company called Toy Giraffe Inc.
As the name suggests, this is a company buying and selling toy giraffes.
In the first quarter of the year, Toy Giraffe Inc is building up its inventory.
In January, they buy 100 units (packed in 2 boxes of 50 units each) at $5 per unit.
In February, 200 units (4 boxes of 50 units) at $6 per unit.
In March, another 100 units (2 boxes of 50 units) at $7 per unit.
As you see, the cost per unit for toy giraffes is going up fast.
The Q1 ending inventory is 400 units at a total purchase price of $2400, so on average
$6 per unit.
In the warehouse, the company does not specifically identify the boxes, they just stack them on
a big pile.
For cost accounting and inventory valuation purposes, the company does keep track of the
timing of the buys and the unit cost.
Then we go to April.
The ending inventory of Q1 is the beginning inventory of Q2.
The first box of toy giraffes (50 units) is sold in April.
The ending inventory is 7 boxes of 50 units each, 350 units in total.
For inventory valuation as well as determining Cost Of Goods Sold, it is important to determine
what is the cost per unit for this specific box.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first, so we
assume that the box sold originated from the January buy.
What remains in inventory at the end of April is 50 units from the January buy, the full
200 units from the February buy, and the full 100 units from the March buy.
In total, 350 units with a total purchase price of $2150, so on average $6.14 per unit.
If we prepare the income statement for April, revenue is 50 units times $10 = $500,
Cost Of Goods Sold (or COGS) is 50 units times $5 = $250, and Gross Profit is $250.
Out of the January buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
Onward to May.
The ending inventory of April is the beginning inventory of May.
Two boxes of toy giraffes are sold in May.
The ending inventory is 5 boxes of 50 units each, 250 units in total.
We once again apply FIFO, First In First Out,
and assume that the oldest inventory gets sold first.
What remains in inventory at the end of May is zero units from the January buy, 150 units
from the February buy, and the full 100 units from the March buy.
In total, 250 units with a total purchase price of $1600, so on average $6.40 per unit.
If we prepare the income statement for May, revenue is 100 units times $10 = $1000,
Cost Of Goods Sold (or COGS) is 50 units times $5 = $250 plus 50 units times $6 = $300, and
Gross Profit is $450.
Out of the remaining January buy that was part of the beginning inventory, we took all
50 units to COGS, and we took 50 units from the February buy into COGS.
The remaining 150 units from the February buy go to the ending inventory.
Onward to June.
The ending inventory of May is the beginning inventory of June.
Four boxes of toy giraffes are sold, sales are really picking up pace.
The ending inventory is just 1 box of 50 units each.
We once again apply FIFO, First In First Out, and assume that the oldest inventory gets
sold first.
What remains in inventory at the end of June is just 50 units from the March buy: 50 units of
$7 each, $350 in total.
If we prepare the income statement for June, revenue is 200 units times $10 = $2000, Cost
Of Goods Sold (or COGS) is 150 units times $6 = $900, plus 50 units times $7 = $350,
so total COGS of $1250, and therefore a Gross Profit of $750.
Out of the remaining February buy that was part of the beginning inventory, we took all
150 units to COGS, and we took 50 units from the March buy into COGS.
The remaining 50 units from the March buy go to the ending inventory.
Summary and conclusion.
FIFO, First In First Out, is an accounting fiction in cost accounting that is a major
determinant of Cost Of Goods Sold and Gross Profit.
If cost per unit goes up over time, and selling price stays flat, you make the highest profit
per unit in the earlier periods,
as you apply the fiction of “selling the oldest inventory first”.
Thank you for watching!
The related videos on inventory accounting using the LIFO method, and the comparison
between FIFO and LIFO could be also useful for you.
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