The FIFO Method for Cost of Goods Sold
With the FIFO (first-in, first-out) method for cost of goods sold, you charge out product costs to cost of goods sold expense in the chronological order in which you acquired the goods. It’s like the first people in line to see a movie get in the theater first. The ticket-taker collects the tickets in the order in which they were purchased.
Suppose that you acquire four units of a product during a period, one unit at a time, with unit costs as follows (in the order in which you acquire the items): $100, $102, $104, and $106. By the end of the period, you have sold three of these units. Using FIFO, you calculate the cost of goods sold expense as follows:
$100 + $102 + $104 = $306
In short, you use the first three units to calculate cost of goods sold expense. The cost of the ending inventory asset, then, is $106, which is the cost of the most recent acquisition.
The $412 total cost of the four units is divided between $306 cost of goods sold expense for the three units sold and the $106 cost of the one unit in ending inventory. The total cost has been accounted for; nothing has fallen between the cracks.
FIFO works well for two primary reasons:
Products generally move into and out of inventory in a first-in, first-out sequence. The earlier acquired products are delivered to customers before the later acquired products are delivered, so the most recently purchased products are the ones still in ending inventory to be delivered in the future.
Using FIFO, the inventory asset reported in the balance sheet at the end of the period reflects recent purchase (or manufacturing) costs, which means the balance in the asset is close to the current replacement costs of the products.
When product costs are steadily increasing, many businesses follow a first-in, first-out sales price strategy and hold off raising sales prices as long as possible. They delay raising sales prices until they have sold their lower-cost products. Only when they start selling from the next batch of products, acquired at a higher cost, do they raise sales prices.