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First-In, First-Out (FIFO) Method - Inventory Methods in Financial Accounting

The first-in, first-out (FIFO) method assumes that the costs of the first items acquired should be assigned to the first items sold. The costs of the goods on hand at the end of a period are assumed to be from the most recent purchases, and the costs assigned to goods that have been sold are assumed to be from the earliest purchases. Any business, regardless of its goods flow, can use the first-in, first-out (FIFO) method because the assumption underlying it is based on the flow of costs, not the flow of goods.

In the following illustration, the FIFO method would result in an ending inventory of $6,100, computed as follows:

Periodic Inventory System—FIFO Method

Thus, the FIFO method values ending inventory at the most recent costs and includes earlier costs in cost of goods sold. During periods of rising prices, FIFO yields the highest possible amount of net income because cost of goods sold shows the earliest costs incurred, which are lower during periods of inflation. Another reason for this is that businesses tend to raise selling prices as costs increase, even when they purchased the goods before the cost increase. In periods of declining prices, FIFO tends to charge the older and higher prices against revenues, thus reducing income. Consequently, a major criticism of FIFO is that it magnifies the effects of the business cycle on income.

Because of their perishable nature, some products, such as milk, require a physical flow of first-in, first-out. However, the inventory method used to account for them can be based on an assumed cost flow that differs from FIFO, such as average-cost or last-in, first-out (LIFO).

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