Calculating Cost Using First-In, First-Out (FIFO)
The First-In, First-Out method, also called FIFO, is the most straight-forward of all the methods. When determining the cost of a sale, the company uses the cost of the oldest (first-in) units in inventory. This does not necessarily mean the company sold the oldest units, but is using the cost of the oldest ones. When I think of FIFO, it reminds me of milk being sold at the grocery store. In most grocery stores, the coolers are built to allow staff to put the new milk in from the back, pushing the old milk forward, and encouraging shoppers to purchase the older milk (first-in) before the new milk.
When the cost of inventory is rising, FIFO will ensure that the older, less expensive inventory cost is transferred to Cost of Goods Sold. This creates a lower expense on the income statement and higher profit. Higher profit also leads to higher income taxes. Inventory on the balance sheet will be higher than when using other inventory methods, assuming costs are rising.
The wonderful thing about FIFO is that the calculations are the same for both periodic and perpetual inventory systems because we are always taking the cost for the oldest units.
All periodic inventory systems calculate inventory at the end of the period. Therefore, we are not concerned about which units are on hand when a sale occurs. When calculating any inventory method under periodic, it is best to separate the purchases from the sales.
We now have a much clearer picture of what happened during the month of January. Our goods available for sale (beginning inventory plus purchases) is 415 units or $3,394. We know we sold 245 units during the month. When using FIFO, we pick the units that were acquired first and use the cost of those units first. We keep picking units until we have accounted for the cost of all the units sold, in this case 245 units.
First we select the units from beginning inventory.
That gives us 150 of the 245 units we need. We still need 95 more units. We move to the first purchase on January 3.
Taking all the units from January 3 still leaves us 20 units short of the 245 units we need. We will take those 20 units from the 50 purchased on January 12.
We have now accounted for all 245 units sold and have determined that the cost of those units is $1,972.50. We sold the units for $4,900. Now we can calculate gross profit. Gross profit is sales less cost of goods sold. Gross profit tells us how much profit we are making off the sale of our product before all other expenses.
Our gross profit is $2,927.50. Remember that as prices rise, FIFO will give you the lowest cost of goods sold because the oldest and least expensive units are being sold first. This also gives us the highest gross profit.
Now to calculate ending inventory. Remember that ending inventory is what is left at the end of the period. The units from beginning inventory and the January 3rd purchase have all been sold. The company also sold 20 of the 50 units from the January 12 purchase. That leaves 30 units from that purchase and the units purchased on January 22 and 26.
Ending inventory contains 170 units with a value of $1,421.50. To ensure we accounted for all the units and their value, add cost of goods sold and ending inventory.
This agrees to our original goods available for sale. While this check figure will not ensure that you picked the right units, it will ensure that you accounted for all the units and calculated the cost correctly.
As stated previously, FIFO periodic and FIFO perpetual will give you the same result for cost of goods sold and ending inventory. However, with perpetual inventory systems we must be concerned with calculating cost of goods sold at the time of each sale.
When calculating using the perpetual systems, do not separate purchases and sales. At the time of each sale, we must consider what units are actually available to be sold. Only consider units that are on hand at the time of the sale. Look at the sale on January 7. What units are on hand on that date? The company has the units from beginning inventory and the purchase on January 3rd.
If we take 100 units out of inventory, we would take them from beginning inventory.
The cost of goods sold for the January 7th sale is $800. That would leave 50 units from beginning inventory and 75 from the purchase on January 3rd. Now we can move on to the next sale on January 17. Update the list of goods available for sale to reflect what was sold and the additional purchase on January 12.
The company sold 65 units on January 17. Using FIFO, we would take the first units in, taking 50 units left from beginning inventory and an additional 15 from the purchase on January 3rd.
The cost of the January 17th sale is $521.50. We have now used up all the units from beginning inventory and 15 of the units from January 3rd. Now let’s look at the last sale, again updating what is on hand as of that date.
The sale on January 31 of 80 units would be taken from the purchase on January 3rd and the purchase on January 12th.
The total cost of the sale is $651.00. We can now figure out the total cost of goods sold for the month by adding the cost of goods sold from each transaction.
Cost of goods sold for the month of January is $1,972.50. Notice this is the same as the cost of goods sold calculated until FIFO periodic. We can also calculate ending inventory, which is just the sum of what is left over.
If we add cost of goods sold and ending inventory, we get $3,394.00 which is our goods available for sale.
Remember that under FIFO, periodic and perpetual inventory systems will always give you the same cost of goods sold and ending inventory. This will only occur under FIFO.
When doing this by hand, I always cross out the number of units and write in the remaining amount. This is much faster than rewriting the list. Keeping track of the number of units remaining will help to ensure that you take your units from the correct date and calculate ending inventory properly.
FIFO Inventory Calculations
FIFO Inventory Journal Entries