Contrast FIFO with the weighted average cost method
The idea
FIFO assumes the oldest units are sold first; the weighted average cost method pools all units and applies an average. When prices are rising, FIFO charges older, cheaper units to cost of goods sold, producing lower COGS, higher net income, and ending inventory closer to current cost. Weighted average lands between FIFO and the outcome of charging newest costs first. The effects reverse when prices fall. Because the choice changes reported profit without changing the underlying business, comparing companies means checking which method each uses.
Formulas
Inventory and cost of goods sold
ending inventory = beginning inventory + purchases − cost of goods sold
- beginning inventory
- what was on hand at the start
- purchases
- stock bought or produced during the period
- cost of goods sold
- the cost of what was sold
The identity behind every cost flow method. FIFO and weighted average do not change the total, only how it splits between the balance sheet and the income statement — so whatever one gains the other loses.
A practice question
Under FIFO, the units assumed to be sold first are:
- the oldest units in inventory — correct
- an average of all units heldWhy not: That is the weighted average cost method, which pools every unit into one cost.
- the newest units in inventoryWhy not: That is LIFO — last in, first out. FIFO takes the earliest costs first, which is what the name says.
First in, first out: the earliest costs move to cost of goods sold, leaving the most recent costs in ending inventory.
A harder one
In a period of rising prices, FIFO compared with weighted average cost produces:
- higher COGS and lower net incomeWhy not: That is the direction when prices *fall*, or what LIFO does when they rise. FIFO charges the oldest and therefore cheapest units.
- lower COGS and higher net income — correct
- identical COGS and net incomeWhy not: They coincide only when prices are flat. A price trend is exactly what opens the gap.
FIFO charges the older, cheaper units to COGS. Lower COGS means higher reported profit — without any difference in the underlying business.
The hardest tier
A company using FIFO reports rising gross margins during a period of sharply rising input costs. This most likely reflects:
- a genuine improvement in pricing powerWhy not: Possible, but FIFO produces exactly this pattern with no change in pricing power at all — which is why the method has to be ruled out before the conclusion is drawn.
- an error in the inventory recordsWhy not: The pattern is what correct FIFO accounting produces in a rising-cost period. Nothing needs to be wrong for it to appear.
- older, cheaper costs flowing through COGS — correct
FIFO matches current selling prices against older, cheaper costs, which flatters the margin. Distinguishing this from real pricing power is exactly why the method matters.
In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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