Fifo Lifo

The FIFO LIFO cost flow assumptions are the most popular methods of assigning costs to inventory. FIFO inventory, or first in first out, assumes that the first goods purchased are the first goods used or sold.

Fifo Lifo Cost Flow Assumptions

Identifying each and every item in inventory is neither practical nor not cost-effective for large volumes of inventory. Specific identification is better suited for low turnover, high value items that are more easily tracked, such as vehicles, heavy machinery, high priced jewelry, or custom homes.

For most businesses, thousands and even millions of items held in inventory require a more cost-effective and practical way to measure cost of goods sold and inventory. The four main cost flow methods used to for inventory accounting and inventory cost are FIFO, LIFO, average cost, and specific identification.

These cost flow assumptions simplify cost of goods sold and inventory accounting by reducing information required to a few data points in the cost flow process, as opposed to tracking the fluctuating cost of every inventory item that are quickly buried and obscured in the cost flow process.

Specific Identification Inventory Accounting Illustrated

For example, the actual physical flow of inventory items which Sunny purchased over the past three months are as follows:

Actual Physical Flow of Inventory

Sunglasses Purchased two months ago:	Sunglasses Purchased one month ago:	Sunglasses purchased this week:
240 Sunglasses @$14 each:	240 Sunglasses @$15 each:	240 Sunglasses @$16 each:
$3,360	–	–
–	$3,600	–
–	–	$3,840

When Sunny sells twenty five pairs of sunglasses one sunny afternoon, it is unlikely he knows which original order the pair of sunglasses came from. Unbeknownst to Sunny, the first twelve sunglasses came from Box 1 at $14 each, the next ten sold came from Box #2 at $15 each, and the last three pairs came from Box #3 at $16 each. If Sunny tracked every pair of sunglasses coming in, he would total his cost of goods sold based on specifically identifying the cost of each inventory item:

Inventory Cost of Goods Sold Using Specific Identification

Sunglasses Purchased two months ago:	Sunglasses Purchased one month ago:	Sunglasses Purchased this week:
12 @ $14:	10 @ $15:	3 @ $16:
$168	$150	$48
Total COGS: $366

Inventory Reporting Using Specific Identification

Sunglasses Purchased two months ago:	Sunglasses Purchased one month ago:	Sunglasses Purchased this week:
228 @ $14:	230 @ $15:	237 @ $16:
$3,192	$3,450	$3,792
Ending Inventory: $10,434

FIFO LIFO Inventory Accounting

FIFO Inventory Illustrated

Alternatively, Sunny can calculate cost of goods sold and ending inventory based on the cost flow assumption that the first inventory items ordered are the first items sold. He would not need to know the price of each item, but only the amount of inventory in each purchase, including beginning inventory.

Since the first items ordered two months ago cost $14 a pair, and the amount sold was 25 pairs of sunglasses, all of the pairs sold are applied to cost of goods sold at $14 per pair, the cost from the first box ordered, assuming no beginning inventory:

FIFO Inventory Cost of Goods Sold

Inventory Purchase two months ago:	Inventory Purchase one month ago:	Inventory Purchase this week:
25 @ $14:	0 @ $15:	0 @ 16:
$350	–	–
Total COGS: $350

Similarly, ending inventory is based on the cost flow assumption that the first items in were sold, and the last items in are still here (LISH):

FIFO Inventory Reporting

Sunglasses Purchased two months ago:	Sunglasses Purchased one month ago:	Sunglasses purchased this week:
215 @ $14:	240 @ $15:	240 @ $16:
$3,010	$3,600	$3,840
Ending Inventory: $10,450

Note that the specific identification method, FIFO and LIFO all result in total goods available for sale of $10,800, but FIFO assigns less to cost of goods sold and more to ending inventory during periods of rising prices, while LIFO assigns more to cost of goods sold and less to ending inventory during the same period.

Strengths and Weaknesses of FIFO Inventory Reporting and Inventory Cost

FIFO Inventory Strengths:

The FIFO inventory method more closely parallels the actual physical flow of inventory items, where earlier inventory purchases are sold, and more recent items remain in inventory. Consequently, items remaining in inventory under FIFO show inventory at the more recent cost on the balance sheet.
Unlike LIFO, the FIFO inventory method did not originate from the income tax code, and is thus not subject to the complex IRS rules and regulations that govern the use of LIFO.

FIFO Inventory Weaknesses:

FIFO inventory cost does not accurately match the current cost of goods sold with revenue, since lower, historical cost of goods sold are being charged against current revenue, potentially misstating and inflating income for the period reported during periods of increasing prices.
In periods of rising prices, the FIFO inventory cost of goods sold will result in a higher income tax liability. (However, in deflationary periods, FIFO will result in a lower income tax liability.)

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