The FIFO Method (First in, First Out) is a valuation method that assumes the first goods purchased or produced are sold first. In theory, a business sells its oldest inventory items before selling new inventory to its customers.
The opposite of the FIFO method would be the Last In, First Out (LIFO) method.
Example of the FIFO Method
John sells bottled water to customers. He buys the water in cases of 25 bottles each. He buys one case on Monday, a second on Tuesday, and a third on Thursday. John has 75 bottles of water in his warehouse. If John sells five bottles of water to customers on Friday, it is assumed the bottles were pulled from the case purchased on Monday, even though they very well could have come from the case purchased on Tuesday or Thursday.
Impact of FIFO Method?
Higher Inventory Valuation. Using the FIFO method generally results in a higher inventory valuation on the company balance sheet. Inventory value is higher because inflation usually raises the costs of all goods purchased. By selling the lower-cost older inventory first, the higher-cost inventory remains on the company’s balance sheet.
Higher Net income. FIFO also generates higher net income because the company’s cost of goods sold (COGS) is lower. By expensing the lower-cost inventory purchased first, the COGS expense at year-end will be lower than if using the LIFO method.
Higher Taxes. If the FIFO method results in higher net income, it will generally result in a larger income tax bill. Greater profits mean greater taxes.