The first in, first out valuation method ties the cost of goods sold to the oldest items in inventory. It is essentially a chronological method of valuation: it assumes that the first items purchased are the first ones sold. In this respect, it does a better job than LIFO of matching products created with the revenue generated by the sale of those products.
If prices are rising, the FIFO method results in lower cost of goods sold and, therefore higher earnings and profit figures, higher taxes, and higher ending inventory values, and as a result, is generally considered to be a more “aggressive” approach from an accounting perspective. FIFO generally results in a more accurate, or at least not artificially low, ending inventory.
Example Question
Footwear retailer Shoe Gulag starts the year with an inventory of 1 million identical pairs of its “Archipelago” model shoes. Each pair of shoes had a cost of $18. During the year, Shoe Gulag sells 1.2 million pairs of Archipelago shoes. During the year, it purchases 400,000 pairs in February at a cost of $19, 300,000 pairs in June at a cost of $21, and 500,000 in October at a cost of $22. Shoe Gulag’s fiscal year is the same as the calendar year. What is the value of its inventory at the end of the year, under LIFO and FIFO?
Answer: LIFO: $18 million; FIFO: $21.1 million. Recall that the inventory equation is:
ending inventory = beginning inventory + purchases – cost of goods sold
Under either LIFO or FIFO, the beginning inventory and purchase amounts are the same; only the cost of goods sold, and thus, ending inventory will differ.
The figures in the question above provide the following results:
