Costing stock is an assumption about which units were sold, not an observation of it, and that assumption changes reported profit and the balance sheet.
This method assumes the oldest units go first. It suits most businesses, it matches how stock physically moves in many of them, and it demands one thing in return: accurate layers, with landed cost captured at the point of purchase rather than estimated afterwards.
This covers how the method works, a worked example through several purchase layers, what happens to reported results when prices move, how it compares with the alternative, and what it asks of the records.
FIFO (First In, First Out) is the most common inventory valuation method. Under FIFO, the first units purchased are assumed to be the first units sold. The cost of goods sold uses the oldest purchase prices; ending inventory uses the most recent (newest) prices.
How FIFO Works
When you sell a unit, you draw from the oldest cost layer first. Once that layer is exhausted, you move to the next oldest.
The method is only as good as the layers behind it. Landed cost has to be captured at purchase rather than estimated later, because once freight and duty are missing from a layer, every cost of sales figure drawn from it is understated and the error compounds through the year.
Anu Gupta, CA, EA, B.Tech · LinkedInFIFO Example with Three Purchase Layers
| Purchase Date / Layer | Units x Cost |
|---|---|
| January: Layer 1 | 100 units @ $10 each = $1,000 |
| March: Layer 2 | 150 units @ $12 each = $1,800 |
| June: Layer 3 | 200 units @ $14 each = $2,800 |
| Total Purchased | 450 units, total cost $5,600 |
If you sell 200 units:
| Units Sold | FIFO Cost |
|---|---|
| First 100 units (Layer 1) | 100 x $10 = $1,000 |
| Next 100 units (Layer 2) | 100 x $12 = $1,200 |
| COGS for 200 units | $2,200 |
| Ending Inventory (250 units) | 50 @ $12 + 200 @ $14 = $3,400 |
FIFO in Rising vs Falling Prices
| Scenario | FIFO Effect |
|---|---|
| Rising prices (inflation) | Lower COGS (uses older cheaper costs), higher gross profit, higher taxable income |
| Falling prices (deflation) | Higher COGS (uses older more expensive costs), lower gross profit, lower taxable income |
| Stable prices | FIFO and LIFO produce identical results |
FIFO vs LIFO
| Dimension | FIFO |
|---|---|
| Permitted under IFRS? | Yes |
| Permitted under US GAAP? | Yes |
| COGS in rising prices | Lower |
| Ending inventory value | Higher (closest to current market cost) |
| Tax impact in rising prices | Higher taxes |
| Balance sheet accuracy | Better, inventory reflects recent costs |
When FIFO Makes Sense
- Perishable goods: food, beverages, pharmaceuticals, physical FIFO matches accounting FIFO
- Products with expiration dates or model-year obsolescence
- Fashion and seasonal goods where old inventory loses value
- Companies reporting under IFRS (LIFO is not an option)
- Companies wanting balance sheet inventory close to current replacement cost
Balance Sheet Impact
Under FIFO, ending inventory on the balance sheet reflects the most recent purchase prices, close to current market value. This makes the balance sheet more useful for assessing true asset value, especially in inflationary periods.
Where the Method Meets the Physical Count
A costing method is an assumption about which units left, and the stock count is the moment that assumption meets reality. The two are related but they are not the same exercise, and confusing them is how businesses end up with a stock figure nobody can explain.
The count establishes how many units you have. The method establishes what those units cost. When the count comes back lower than the ledger, the difference is shrinkage, and it is a cost of the period rather than an adjustment to the method: units were lost, damaged, miscounted or taken, and no costing assumption changes that. Applying the difference as a cost correction instead buries a real operational problem inside the margin, where it will not be found.
The second interaction is valuation. A costing method says what stock cost, not what it is worth, and stock that will sell below cost has to come down to what it will actually fetch. Under this method the oldest layers stay on the balance sheet longest, so slow lines quietly sit there at prices the market moved away from. Reviewing the oldest layers at each count, rather than only the quantities, is what stops that accumulating.
- Count and cost as two separate steps, and record the quantity difference before any value is adjusted
- Post shrinkage as its own line rather than folding it into cost of sales, so the trend is visible
- Review the oldest remaining layers at every count for anything that will not sell at the price it is carried at
- Keep the count sheets with the valuation working, because the two together are what an auditor or a buyer will ask to see
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Frequently Asked Questions
Does FIFO mean I physically ship the oldest inventory first?
FIFO is an accounting assumption, not necessarily a physical requirement (though for perishables, the physical and accounting FIFO usually match). You can use FIFO accounting even if warehouse picking is not strictly oldest-first.
What is the FIFO perpetual inventory system?
In a perpetual system, COGS and inventory are updated with each sale in real time, not just at period end. Most modern inventory software uses perpetual FIFO.
Can I switch from LIFO to FIFO?
Yes, but it requires IRS approval (Form 3115) and creates a one-time catch-up adjustment to income. The LIFO Reserve must be recognised as income in the year of change.
Do we have to use the same method every year?
Yes, consistency is the point of choosing one. Switching method changes both reported profit and the balance sheet without anything happening in the business, so a change is treated as a change in accounting method rather than an ordinary decision, needs a reason you can defend, and generally needs the tax authority's agreement. Decide deliberately at the start rather than picking whichever suits a given year.
What does FIFO require us to actually keep track of?
Layers: for each item, what you paid and when, and how much of each purchase remains. That is the part businesses underestimate, because it means landed cost has to be captured at the point of purchase, not estimated later. Once freight, duty and handling are missing from a layer, every cost of sales figure drawn from it is understated and the error compounds through the year.
Written by
Anu Gupta, CA, EA, B.Tech
Anu works with US businesses on tax and entity questions at Profitjets, from choosing a structure to the filings that follow it. She writes about the decisions owners make once and then live with for years. Connect on LinkedIn
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