The first in, first out, aka FIFO (pronounced FIE-foe), accounting method assumes that sellable assets, such as inventory, raw materials, or components acquired first were sold first. That is, the oldest merchandise is sold first, with its associated costs being used to determine profitability. (In contrast, LIFO – last in, first out – assumes the newest inventory is the first to sell.)
In reality, sales patterns don’t usually follow this simple assumption. You’ll often sell a mix of new and older merchandise.
But FIFO has to do with how the cost of that merchandise is calculated, with the older costs being applied before the newer. This is often different due to inflation, which causes more recent inventory typically to cost more than older inventory.
As a result, profits may be higher with FIFO than with LIFO.
FIFO in practice
Let’s pretend that your store purchased three shipments of stock in the last three months. The summary looks like this:Month Cost of Inventory Retail Price June $1000 $4000 July $2000 $4000 August $3000 $4000
Using FIFO, when that first shipment worth $4,000 sold, it is assumed to be the merchandise from June, which cost $1,000, leaving you with $3,000 profit. The next shipment to sell would be the July lot under FIFO – since it is not the oldest once the June items are sold - leaving you with $2,000 profit.
This assumption that inventory is sold according to age, which works well for companies with seasonal inventories, such as clothing, housewares, and furniture, doesn’t necessarily match up well with companies that routinely introduce new merchandise, such as in the technology space.
Unlike with LIFO, which tends to minimize profits by applying the most recent (and often higher) costs when calculating company profits, FIFO may result in higher profits, thanks to the practice of assuming product costs are older and lower.