First-In, First-Out (FIFO)

First-In, First-Out (FIFO) is an inventory accounting method that operates on a simple, logical principle: the first goods purchased are the first ones sold. Think of a grocer stocking milk; they push the older cartons to the front so they sell first. In the world of accounting, FIFO assumes that a company's inventory flows in the same way. When the company makes a sale, it calculates the cost of that sale using the price of its oldest inventory items. This method has a direct and significant impact on two key figures in a company’s financial reports: the cost of goods sold (COGS) on the income statement and the value of the remaining inventory on the balance sheet. Because these figures influence reported profits, they also affect how much a company pays in taxes. For an investor, understanding FIFO isn't just accounting trivia—it's a crucial lens for viewing a company's real profitability.

Let's demystify this with a quick example. Imagine “Capipedia Coffee Roasters” buys and sells premium coffee beans.

• January: They buy 100 pounds of beans at $10 per pound. (Cost = $1,000)
• February: Prices go up! They buy another 100 pounds, but this time at $12 per pound. (Cost = $1,200)

Now, they have 200 pounds of beans in stock, purchased at two different prices. In March, they sell 120 pounds of coffee. How do we calculate the cost of that sale using FIFO? Simple: first in, first out.

1. The first 100 pounds sold are from the oldest batch (January's purchase).
   • Cost: 100 pounds x $10/pound = $1,000
2. The remaining 20 pounds sold must come from the next batch (February's purchase).
   • Cost: 20 pounds x $12/pound = $240

So, the total COGS for the sale is $1,000 + $240 = $1,240. What about the inventory left on the shelf? They have 80 pounds remaining, all from the more recent (and more expensive) February batch.

• Ending Inventory Value: 80 pounds x $12/pound = $960.

FIFO's main rival in the accounting world is Last-In, First-Out (LIFO), which assumes the newest inventory is sold first. The choice between them matters immensely, especially when prices are changing.

During a period of rising prices (inflation), the choice between FIFO and LIFO creates very different financial pictures:

• FIFO: By selling the older, cheaper goods first, COGS is lower. This makes profits appear higher. The downside? A higher tax bill. However, the inventory value on the balance sheet is more realistic, as it reflects the cost of more recently purchased goods.
• LIFO: By selling the newer, more expensive goods first, COGS is higher. This makes profits appear lower, leading to a lower tax bill (which improves cash flow). The inventory on the balance sheet, however, can be laughably out of date, valued at ancient prices.

It's important to note that LIFO is permitted under U.S. GAAP (Generally Accepted Accounting Principles) but is banned under IFRS (International Financial Reporting Standards), which are used in Europe and many other parts of the world. This is a key difference to be aware of when comparing American and international companies.

As a value investor, you're a financial detective, and accounting methods are your clues. Understanding FIFO helps you see beyond the reported numbers to the underlying business reality.

• Comparing Apples to Apples: If you're comparing two companies in the same industry, but one uses FIFO and the other uses LIFO, you're not making a fair comparison. During inflationary times, the FIFO company will almost always look more profitable on paper. You need to adjust for this to gauge their true operational performance.
• Profit Quality: FIFO profits can be temporarily boosted by inflation. A savvy investor recognizes that these “inventory profits” aren't the result of brilliant management but simply of rising prices. LIFO often gives a more conservative and realistic picture of a company's current earning power.
• Balance Sheet Clues: While FIFO provides a more up-to-date inventory value, a company using LIFO might be sitting on a hidden asset. The difference between the low LIFO inventory value and what it would be under FIFO is called the LIFO reserve. This reserve represents an off-balance-sheet asset that a sharp investor can factor into their valuation.

The Bottom Line: Never take earnings at face value. Always dig into the footnotes of a company's financial statements to see which inventory method it uses. This simple check is a fundamental step in separating accounting illusions from genuine business value.