What is FIFO?

FIFO, which stands for First In, First Out, is a commonly adopted approach in inventory management and accounting.

The core idea behind this method is that the earliest received or manufactured items are the first to be sold or consumed.

This approach is particularly important in sectors dealing with perishable products or those that risk becoming outdated.

By prioritizing the use or sale of older inventory, it helps minimize the chances of goods becoming unsellable or expired.

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How to Calculate FIFO for Heavy Construction Equipment

To calculate FIFO for heavy construction equipment, follow these steps:

1. Gather Inventory Data

List purchases made during the year, including dates, units, and costs per unit.

Purchase Date	Units Purchased	Cost per Unit	Total Cost
Jan 1	2 units	$200,000	$400,000
Apr 1	3 units	$220,000	$660,000
July 1	5 units	$250,000	$1,250,000
Total Inventory		10 units	$2,310,000

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2. Identify Units Sold

At the end of the year, you sold 6 bulldozers.

FIFO assumes the oldest inventory is sold first.

Sold Units	Purchase Date	Cost per Unit	Total COGS
2 units	Jan 1	$200,000	$400,000
3 units	Apr 1	$220,000	$660,000
1 unit	July 1	$250,000	$250,000
Total Sold		6 units	$1,310,000

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3. Calculate COGS (Cost of Goods Sold)

Use the FIFO COGS formula:

COGS = Starting Inventory + Purchases − Ending Inventory COGS = Starting Inventory + Purchases - Ending Inventory COGS = Starting Inventory + Purchases − Ending Inventory

COGS = $0 + $2,310,000 - $1,000,000

COGS = $1,310,000

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4. Calculate Ending Inventory

After selling 6 units, 4 units remain in inventory.

These are from the most recent purchase.

Remaining Units	Purchase Date	Cost per Unit	Total Value
4 units	July 1	$250,000	$1,000,000

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Use the FIFO Ending Inventory formula:

Ending Inventory = Starting Inventory + Purchases − COGS

Ending Inventory = Starting Inventory + Purchases - COGS

Ending Inventory = Starting Inventory + Purchases − COGS

Ending Inventory = $0 + $2,310,000 - $1,310,000

Ending Inventory = $1,000,000

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Example of FIFO in Practice

Imagine a retail store using the FIFO inventory method.

The store receives three batches of products at different prices: $10 per unit, $15 per unit, and $20 per unit.

When the store sells a portion of these items, the FIFO method of inventory pricing ensures the oldest inventory (the $10 per unit items) are sold first.

This method guarantees that the costs of older inventory are reflected in the cost of goods sold (COGS), directly impacting the company’s profitability and tax liabilities.

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Principles and Operational Implementation

The FIFO method operates on the principle that inventory items are used or sold in the order they were received.

To implement FIFO efficiently, businesses often organize their storage systems so that the oldest stock is always the most accessible.

Many companies also use software systems to track inventory and automate FIFO, ensuring that older items are prioritized for use.

FIFO is particularly important in industries dealing with perishable goods such as food, pharmaceuticals, and electronics, where items can easily become outdated or expired.

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Advantages of FIFO

Reduction of Obsolescence Risk: By selling older inventory first, FIFO helps reduce the risk of inventory obsolescence, which is particularly critical for perishable goods or technology products that may become outdated.
Accurate Cost of Goods Sold (COGS): FIFO ensures that the cost of goods sold is based on the oldest inventory costs, which provides a more accurate representation of profitability, particularly when prices are stable or declining.
Improved Financial Reporting: FIFO inventory valuation ensures that older items are sold first, meaning that financial reports reflect the cost of older goods, which typically aligns with market value.

Disadvantages of FIFO

Higher Tax Liability in Inflationary Periods: Since older, cheaper inventory is sold first, COGS remains low, leading to higher profits and higher taxable income. This can increase tax expenses compared to the LIFO method.

Not Always Reflective of Current Costs: FIFO may underestimate the actual cost of sales when prices rise, making it less accurate for profit margins. The cost recorded may be outdated compared to the current market price of inventory.

Can Distort Financial Reporting During Inflation: FIFO can make a company’s balance sheet look stronger than reality, as the remaining inventory is valued at higher recent prices. This might overstate assets and mislead investors.

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Why FIFO is a Popular Inventory Method

FIFO (First-In, First-Out) is widely used because it aligns inventory management with financial reporting and provides an accurate valuation of stock.

1. Accurate Inventory Valuation

FIFO assumes the oldest inventory is sold first, ensuring that the remaining stock reflects current market prices.

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2. Higher Profits During Inflation

When costs rise, older inventory (purchased at lower prices) is recorded as COGS, resulting in higher reported profits.

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3. Minimizes Waste and Obsolescence

Using older inventory first reduces the risk of spoilage, damage, or outdated stock, making it ideal for perishable or time-sensitive goods.

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4. Matches Natural Inventory Flow

Most businesses naturally sell or use older stock first, making FIFO an intuitive and practical method.

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5. Simple and Easy to Apply

FIFO is easier to implement than LIFO or Weighted Average Cost, making it ideal for businesses of all sizes.

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6. Supports Financial Planning

With clear inventory costs and profit margins, FIFO helps businesses make informed pricing and purchasing decisions.

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Practical Applications of FIFO

FIFO is applied across various industries, especially where inventory turnover is high, or where goods have a shelf life:

Construction: FIFO ensures that older construction equipment (bulldozers, excavators, cranes) is sold or rented out first. This prevents depreciation losses and ensures that machines are used before they become outdated.

Retail: FIFO ensures that the oldest stock is sold first, which aligns with customer expectations for fresh products.

Manufacturing: FIFO helps optimize production by ensuring that materials that have been in inventory the longest are used first, minimizing holding costs.

Pharmaceuticals and Food: FIFO is critical for these industries, as products have expiration dates. It guarantees that the oldest products are used or sold before they expire.

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Financial Implications and Reporting

The FIFO method significantly impacts construction inventory valuation and the calculation of COGS.

Since FIFO uses older inventory costs to determine COGS, it can result in lower COGS during times of rising prices, leading to higher profits and tax liabilities.

However, in a stable or declining price environment, FIFO reflects a more accurate measure of the inventory's market value.