FIFO Method

The FIFO (First In, First Out) method is a strategy for managing and valuing inventory. It’s based on the principle that the first items to enter your inventory are the first ones sold from ending inventory. Particularly useful in industries where products are perishable, such as food and beverages, FIFO, as a valuation method, helps ensure you sell goods in the order they were acquired, keeping your stock fresh and reducing waste.

Under FIFO, cost of goods sold (COGS) reflects the cost of the earliest-purchased inventory, while remaining inventory on the balance sheet reflects more recent purchase prices. 

The FIFO method is recognized under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). However, applying it consistently and reflecting it accurately in your financial statements is essential to meet legal and regulatory standards.

How the FIFO method works

FIFO assumes, for accounting purposes, that the first units purchased are the first units sold. This is a cost flow assumption, not a requirement about how goods physically move.

The logic is straightforward:

• Record inventory purchases or production costs in the order the business acquires or produces them.
• When a sale occurs, assign the oldest available inventory cost to cost of goods sold.
• The remaining inventory generally reflects the cost of the most recently purchased or produced units.

Example: A retailer buys 100 units at $10 in January and 100 units at $12 in February, then sells 100 units in March. FIFO assigns the $10 cost to COGS. The remaining 100 units carry a value of $12 on the balance sheet.

Why the FIFO method matters

The choice of inventory method directly affects reported profits, tax liability, and balance sheet accuracy. During periods of rising prices, FIFO assigns older, lower-cost inventory to COGS, resulting in higher reported gross profit than alternatives like LIFO (Last In, First Out).

Common uses

FIFO suits businesses where inventory costs change frequently or where products have a limited shelf life. These are the industries where it sees widest use.

• Grocery and food retail: FIFO accounting mirrors the physical practice of rotating older stock first.
• Pharmaceuticals: FIFO aligns accounting with regulatory requirements around product expiration.
• Electronics retail: Older, lower-cost units expense first, keeping COGS lower during periods of inflation.
• Manufacturing: FIFO assigns earliest material costs to production runs, keeping cost structure transparent.

FIFO vs. LIFO

LIFO (last in, first out) assigns the most recently purchased inventory to COGS first, typically producing lower reported profit and lower taxable income during inflationary periods. LIFO is allowable under GAAP but not permitted under IFRS, limiting its use for businesses with international reporting obligations.

Switching inventory methods after adoption requires IRS Form 3115 and can affect taxable income across multiple years. A business considering this change should consult a qualified accountant first.

Limitations

During inflationary periods, FIFO can produce higher taxable income because lower historical costs match against current revenue, sometimes called “phantom profit.” Businesses with thin margins or large, frequently restocked inventories may feel this effect more strongly.

FIFO also assumes a consistent cost flow that may not reflect operational reality for every business. Companies that discount older inventory or sell in irregular patterns may find a mismatch between accounting records and actual performance.

Related terms

The FIFO method connects to several broader financial and ownership concepts that affect how a business tracks costs and reports results.

• Cost of goods sold (COGS): Cost of goods sold is the direct cost of products a business sells during a specific period.
• Weighted average cost: Weighted average cost values inventory by using an average per-unit cost across similar items available for sale.
• Specific identification: Specific identification matches the actual cost of a particular item to that item when the business sells it.

FAQs about FIFO method

Does FIFO have to match how inventory physically moves?

No. FIFO is a cost flow assumption. A business can apply it for accounting purposes even if it doesn’t literally sell the oldest items first, though in many industries the two naturally align.

Why does FIFO result in higher taxes during inflationary periods?

FIFO assigns older, lower-cost inventory to COGS, which widens the gap between historical costs and current selling prices. This produces higher reported profit, sometimes called phantom profit, that is subject to income tax even though it doesn't reflect a real gain in purchasing power.

What other inventory valuation methods are available?

The main alternatives are LIFO (GAAP-only), weighted-average cost, and specific identification. Weighted average cost uses a blended per-unit cost for similar inventory. Specific identification tracks the actual cost of a particular item and is often used for unique or high-value products.