FIFO Method in Inventory Valuation with a Practical Example

First-In, First-Out (FIFO) is an inventory valuation method that assumes the earliest units purchased or produced are sold or consumed first. When a business calculates its cost of goods sold (COGS) using FIFO, the cost of the oldest available inventory is assigned to sales, while the remaining inventory is valued using the most recent purchase costs.

In India, FIFO is one of the two recognised inventory cost formulas under Ind AS 2 (Indian Accounting Standard 2) and AS 2 (Valuation of Inventories), alongside the weighted average cost method. It is also permitted under the Income Computation and Disclosure Standard II (ICDS-II) for computing taxable income under the Income Tax Act, 1961. The Last In, First Out (LIFO) method is not permitted under these standards.

What is FIFO under Indian accounting standards?

Three standards govern inventory valuation in India, and each permits FIFO:

• Ind AS 2 (converged with IAS 2): Applicable to companies that prepare financial statements under Indian Accounting Standards. Ind AS 2 requires inventory to be measured at the lower of cost and net realisable value (NRV). The cost formula must be either FIFO or weighted average cost.
• AS 2 (Valuation of Inventories): Applicable to companies and entities that are not required to apply Ind AS. AS 2 follows the same principle, requiring inventories to be valued at the lower of cost and NRV. For interchangeable inventories, FIFO and weighted average cost are permitted. Specific identification may be used where inventories are not ordinarily interchangeable.
• ICDS-II (Income Computation and Disclosure Standards): For taxpayers maintaining accounts on a mercantile basis, ICDS-II governs the valuation of inventory for computing taxable income under the ITA. It permits only FIFO or weighted-average cost as cost assignment methods. Under this, the inventory must be valued at the lower of cost or NRV.

How is FIFO calculated?

FIFO produces two outputs for any accounting period: the cost of goods sold and the value of closing inventory. Both are derived from the same cost-flow logic, oldest cost first.

• Cost of goods sold (COGS): Add up the cost of the oldest units available until the total units sold in the period are accounted for.
• Closing inventory value: The units remaining after sales are valued at the cost of the most recent purchases.

As a check, the relationship between these figures must always hold:

Opening inventory + Purchases − COGS = Closing inventory

This equation is an accounting identity. If the numbers in a FIFO calculation do not satisfy it, there is an error somewhere in the workings.

Practical example: FIFO in a trading business

Consider X Fabrics, a textile trader based in Mumbai. The business trades in synthetic fabric rolls and opened its financial year on 1 April 2025 with no opening inventory. During April 2025, it made three purchase lots at different prices as costs rose through the month, and made three sales.

Step 1: Record the purchases

Total goods available for sale in April: 350 units at a total cost of ₹77,000.

Step 2: Apply FIFO to each sale

Under FIFO, each sale depletes the oldest batch first. Once a batch is exhausted, the next oldest batch supplies the remaining units.

Step 3: Compute the closing inventory

Seventy units remain from Batch 3 after all three sales (purchased at ₹240 per unit).

Closing inventory: 70 units x ₹240 = ₹16,800

Step 4: Verify using the accounting identity

The equation balances: ₹0 + ₹77,000 − ₹60,200 = ₹16,800. The closing inventory figure of ₹16,800 reflects the cost of the most recently purchased batch (Batch 3), consistent with FIFO.

Impact of FIFO on financial statements

The FIFO calculation feeds directly into the two most important financial statements:

• Profit and loss account: COGS of ₹60,200 is charged as an expense. If total revenue from the 280 units sold was, say, ₹90,000, the gross profit under FIFO would be ₹29,800. FIFO produces higher gross profit in periods of rising prices because it assigns lower, older costs to sales.
• Balance sheet: The closing inventory of ₹16,800 is classified as a current asset, reflecting the most recent purchase price, which is a closer approximation to the current replacement cost.

During periods of rising prices, FIFO often results in higher reported profits and, all else being equal, higher taxable income because lower historical costs are charged to COGS.

What are the advantages of the FIFO method?

The FIFO method offers three practical benefits for businesses managing physical stock:

• Alignment with physical flow: For businesses handling perishable goods, pharmaceuticals, or fast-moving consumer goods (FMCG), FIFO shows the actual order in which goods are used or dispatched.
• Higher closing inventory value on the balance sheet: Because FIFO retains the most recent costs in closing inventory, the balance sheet figure is closer to current replacement cost.
• Reduces obsolescence risk: By systematically clearing older stock first, FIFO reduces the likelihood of stock becoming obsolete before it is sold, a risk that is particularly material in electronics, fashion, and perishable categories.

What are the limitations of the FIFO method?

FIFO also has drawbacks that businesses should weigh before adopting it:

Higher reported profit during inflation leads to higher tax: Because COGS is calculated at older, lower prices, FIFO produces higher gross profit and higher taxable income during periods of rising purchase costs. This increases the income tax liability for the period.

COGS may not reflect current economic reality: In industries where input costs are rising rapidly, the COGS figure reported under FIFO may significantly understate the cost to replace the goods that were sold.

Requires batch-level record keeping: FIFO requires the business to track which purchase lot each unit sold came from. For businesses with high transaction volumes, many purchase lots or maintain multiple storage locations, and maintaining this level of detail manually is burdensome.

Conclusion

FIFO is one of the two recognised cost formulas for interchangeable inventory under Indian accounting and tax regulations. It assigns the earliest purchase costs to sales and retains the most recent costs in closing inventory, resulting in a balance sheet value that is generally closer to current replacement cost.

Its main drawback emerges during periods of rising prices. Because older, lower costs are charged to cost of goods sold (COGS), reported gross profit tends to be higher, which may also increase taxable income.

TallyPrime's inventory management capabilities support batch and lot-level tracking with FIFO cost assignment, helping businesses maintain accurate inventory records and generate COGS and closing inventory values that align with applicable accounting standards.