FIFO (First-In, First-Out)

FIFO (First-In, First-Out) is an accounting method used to manage Inventory and calculate the Cost of Goods Sold (COGS). Imagine a grocery store stocking milk. The first carton placed on the shelf is the first one a customer picks up—the oldest stock is sold first. This is the essence of FIFO. When a company sells a product, it assumes the cost of the oldest item in its inventory is the one to be recorded as the cost of the sale. This simple logic applies not only to physical goods but also to financial assets, like shares of a stock. For an investor, understanding FIFO is crucial because this accounting choice can significantly change a company's reported profits and Taxes, painting a very different picture of its financial health, especially when prices are changing.

Let's step into the shoes of a small business owner, “The Artful Baker,” who sells artisan bread. The price of flour, her main ingredient, fluctuates.

Let's say she makes purchases on two consecutive days:

• Monday: She buys 10 loaves' worth of ingredients for €2 per loaf. (Total Cost: €20)
• Tuesday: The price of flour goes up! She buys another 10 loaves' worth of ingredients for €3 per loaf. (Total Cost: €30)

Her shelf now has 20 loaves of bread that look identical but have different costs.

On Wednesday, a customer buys 15 loaves. How does she calculate her profit? Using the FIFO method, she assumes she sold her oldest inventory first.

1. Step 1: Calculate the Cost of Goods Sold (COGS).
   • She assumes the first 10 loaves sold were the ones from Monday that cost €2 each.
   • The remaining 5 loaves sold were from the Tuesday batch that cost €3 each.
   • Her total COGS is: (10 loaves x €2) + (5 loaves x €3) = €20 + €15 = €35.
2. Step 2: Calculate the value of remaining inventory.
   • She has 5 loaves left, all from the more expensive Tuesday batch.
   • Her ending inventory value is: 5 loaves x €3 = €15.

This calculation directly impacts her Income Statement by defining the cost of the sale, which in turn determines her Gross Profit.

The choice between FIFO and its counterpart, LIFO (Last-In, First-Out), is not just academic; it has real-world consequences for a company's financial reports, especially during periods of Inflation.

When prices are rising, as in our baker's example, FIFO produces some very specific outcomes:

• Lower COGS: By matching older, lower costs with current sales revenue, the reported cost of sales is smaller.
• Higher Profits: A lower COGS naturally leads to higher reported Gross Profit and net income. This can make a company look more profitable than it might actually be, boosting its Earnings per Share (EPS).
• Higher Taxes: Governments tax profits. Higher reported profits mean a bigger tax bill, which drains real cash from the company.
• Higher Inventory Value: The inventory left on the Balance Sheet is valued at the most recent, higher prices, which more closely reflects its current replacement cost.

In a deflationary environment (falling prices), the effects are reversed: FIFO would lead to a higher COGS, lower profits, and lower taxes.

A savvy value investor looks beyond the surface-level numbers. From a value investing perspective, the profits reported under FIFO during inflation can be a mirage.

Warren Buffett and other great investors often talk about “phantom profits.” The higher earnings reported under FIFO are a perfect example. The Artful Baker might report a handsome profit, but to replace the 15 loaves she sold, she must now buy all the ingredients at the new, higher price of €3. Her reported profit overstates her true economic reality because it doesn't reflect the rising cost of staying in business. The cash generated might not be enough to sustain operations at the same level without further investment. A value investor prefers earnings that are backed by strong, real cash flow, not accounting quirks.

This is where comparing FIFO to LIFO becomes essential.

• LIFO: Matches the most recent costs with current revenues. During inflation, this results in a higher COGS, lower reported profits, and a lower tax bill.
• The Value Investor's Preference: Many value investors argue that LIFO gives a more conservative and realistic picture of a company's current profitability. By paying less in taxes, the company preserves cash, which can be reinvested to grow the business—a key component of long-term value creation.

When analyzing a company that uses FIFO in an inflationary industry, a prudent investor should mentally adjust the earnings downward to get a better sense of its true, sustainable earning power.

Here's a critical point for global investors: The choice isn't always available.

• LIFO is permitted under U.S. GAAP (Generally Accepted Accounting Principles).
• However, LIFO is banned under IFRS (International Financial Reporting Standards), which is the standard used in over 140 countries, including the European Union.

This means if you're an American investor looking at a German car manufacturer, or a European investor looking at a French luxury goods company, you know they are not using LIFO. They will be using FIFO or a weighted-average cost method, and you must analyze their financial statements with that in mind.