Definition: FIFO, or First-In, First-Out, is an inventory costing method that companies use to track the cost of inventory that is sold by assuming that the first product purchased is the first product sold. Hence the first product in the door is the first product out of the door.
Since inventory is such a big part of businesses like retailers and manufacturers, it’s important for them to track the inventory that is purchased as well as the inventory that is sold accurately. In theory this sounds simple, but it can be a lot more complex when large companies deal with thousands or even tens of thousands of inventory sku numbers. Without an advanced inventory tracking system, the company has no way of telling when the sold items were actually purchased. That’s why companies use FIFO. It simplifies things.
What Does FIFO Mean?
What is the definition of FIFO? This inventory method allows companies to keep track of inventory and cost of goods sold without actually knowing what specific pieces of inventory were sold during the year. In other words, a retailer might buy 10 shirts in May and 20 shirts in June. If the retailer sold 5 shirts during the year, how does he know which shirts were actually sold—the shirts purchased in May or the ones purchased in June? FIFO assumes that the 5 shirts purchased in May were the ones sold this year because they were the first ones purchased.
Let’s take a look at an example.
Going back to our retailer for example, let’s assume the five shirts that were purchased in May costs $7 per shirt. The shirts purchased in June cost $8.50 per shirt.
If the company sold 5 shirts for the year, Fifo would report costs of goods sold as $35 (5 shirts purchased in May at $7 per shirt). This FIFO cost does not take into full consideration the newer $8.50 per shirt cost of restocking the inventory. In fact, by the time to company will have to purchase more inventory the costs might go up even more than $8.50.
Thus, the FIFO method reports lower costs of goods sold on the income statement and tax return than the company actually incurred for the year. This is a common technique that management uses to increase reported probability. This reporting does have a downside, however. Lower costs and higher profits translates into higher levels of taxable income and more taxes due.
Define Fifo method: Fifo is a way to assign costs to the inventory a company sells to customer and value the inventory the business has on hand at the end of the year by assuming the first items the business purchases are the first it sells to its customers.