The accounting method of first in, first out (FIFO) assumes that merchandise purchased first is sold first. FIFO values all inventory according to the cost of the earliest-purchased merchandise in a given accounting period. In other words, FIFO does not recognize the disparity between the costs of earlier- or later-purchased merchandise. As a result, revenues from merchandise sold are measured against the cost of the earliest-purchased merchandise regardless of any differences in the cost of the merchandise or of the goods themselves.
To illustrate, suppose that at the beginning of a given period, a store buys 10 coffee mugs at a cost of one dollar each. A week later, the store also buys picture frames for $5 each. At the end of the period, the store has sold 10 total items (a combination of coffee mugs and picture frames) for $100 in revenue. Although not all of the 10 items sold were coffee mugs, the revenue the store received from the sale will only be measured against the cost of the 10 coffee mugs ($10) because, as inventory, they were acquired first.
Because inventory can make up a large portion of a company's assets and is an important component of the balance sheet, it is crucial for investors to take the time to understand how inventory is valued.
Though there are tax advantages to using FIFO in the case of higher first-in inventory costs, FIFO can result in higher taxes in the event of inflation combined with the sale of more recently-purchased items.