How does the 'FIFO' inventory method function?

The FIFO (First In, First Out) inventory method operates on the principle that the oldest inventory items are sold first. This means that when a company sells its products, it is assumed that the products purchased first (or produced first) are the ones being sold before any newer inventory.

Using FIFO can have significant implications for financial reporting and tax calculations. In periods of rising prices, FIFO typically results in lower cost of goods sold, as the older, cheaper inventory costs are matched against current revenues. This leads to higher reported profits and corresponds to a higher taxable income.

Additionally, FIFO helps businesses manage their inventory efficiently and is often used in industries where products have a shelf life, such as food and pharmaceuticals, because it minimizes the risk of obsolescence.

This understanding of FIFO highlights its operational and accounting significance, illustrating that the method aligns sales with the order of inventory acquisition, affecting both financial outcomes and inventory management practices.