Understanding the First in First Out (FIFO) Method for Material Pricing

When a factory issues raw material to the shop floor, someone has to decide which purchase price to charge against that job. Materials bought on different dates almost always carry different rates, thanks to inflation, discounts, or supplier changes. The First in First Out (FIFO) method solves this problem with a simple rule: whatever material came into the store first gets sent out first. It sounds almost too straightforward for a cost accounting topic, but this single assumption changes how production costs, profits, and closing stock values are reported.

What FIFO actually assumes 🔗

FIFO is one of several methods used to price the issue of materials from stores, alongside LIFO, simple average, and weighted average. Under FIFO, the earliest consignment received is treated as the first one consumed. Once that lot is fully used up, the price of the next available lot is applied, and so on. This is explained clearly in cost accounting material issued by eGyanKosh, which notes that the cost of the earliest consignment is taken first, and once that batch is exhausted, the price of the next consignment takes over.

It is worth remembering that FIFO is only an accounting assumption. The actual physical material issued from the godown need not be the oldest stock on the shelf. A storekeeper may hand out whichever bag is closest to the door. FIFO only governs how the accountant prices that issue in the books, not how goods physically move.

How a FIFO stores ledger works 🔗

The easiest way to understand FIFO is to walk through a stores ledger account. Suppose a company starts the month with 100 units of a raw material valued at ₹50 each. During the month, it receives 200 units at ₹55 on the 5th, and another 150 units at ₹60 on the 15th. On the 20th, the production department requisitions 250 units.

Under FIFO, the issue on the 20th is priced like this: the first 100 units come from the opening stock at ₹50, and the remaining 150 units come from the 5th’s purchase at ₹55, since that lot was received before the 15th’s lot.

After this issue, the closing stock consists of 50 units from the 5th’s purchase (at ₹55) and the full 150 units from the 15th’s purchase (at ₹60), giving a closing value of ₹11,750 for 200 units. Notice that the closing stock is now valued at prices closest to the current market rate, because the oldest, cheapest layers have already been used up in the issue.

Why the closing stock reflects current prices 🔗

This is the core logic behind FIFO. Because issues are always charged at the oldest available rate, whatever remains in stock is automatically valued closer to the latest purchase price. Study material used by the Institute of Chartered Accountants of India lists several factors organisations weigh before choosing a pricing method, including price fluctuations and the nature of the business, and FIFO’s tendency to keep closing stock near current values is a major reason it remains popular.

This matters for the balance sheet. Inventory sitting close to today’s replacement cost gives a more realistic picture of a company’s working capital than inventory frozen at old, possibly irrelevant, prices.

FIFO when prices are falling 🔗

The outline for this topic focuses on one specific scenario: falling prices. When material costs are trending downward, the oldest purchases in stock are the most expensive ones. Since FIFO always issues the oldest layer first, the cost charged to production during a period of falling prices is higher than what a fresh purchase would cost today.

The result is a higher cost of goods sold and, consequently, lower reported profit, even though the company may be purchasing new material more cheaply. At the same time, the closing stock, valued at the most recent and lowest prices, aligns neatly with current market values. This is actually a conservative and prudent outcome from an accounting standpoint, since it avoids overstating the value of unsold inventory. eGyanKosh’s material on pricing the issue of materials specifically notes that this method of pricing suits situations where prices are falling.

What happens when prices rise instead 🔗

The opposite plays out when material prices are climbing. FIFO then charges production at the older, cheaper rates, understating the true cost of production compared to current replacement cost. This inflates reported profit on paper, even though the business will have to pay more to restock the same material. Because of this, FIFO is sometimes criticised for showing artificially high profits during inflationary periods, a point echoed in cost accounting notes on pricing of material issues, which point out that production cost is understated when prices are rising under FIFO.

Why FIFO is easy to work with 🔗

Beyond its price-matching behaviour, FIFO has a few practical strengths that make it a default choice in many organisations.

Simplicity: The logic mirrors how most people already think about stock rotation, so it needs no complicated averaging or recalculation every time a new purchase arrives.

Prevents obsolete stock: Since the oldest material is always issued first, FIFO discourages materials from sitting unused for long periods, which matters a great deal for perishable items, chemicals with a shelf life, or components that risk becoming technologically outdated.

Logical and realistic: In most stores, especially those handling perishable or degradable materials, the physical flow of goods genuinely does follow a first-in, first-out pattern, so the accounting assumption is not far removed from reality.

Where FIFO falls short 🔗

FIFO is not free of drawbacks. When a business receives several lots at very different prices within a short period, tracking each layer separately for costing purposes becomes tedious. Comparing the cost of two production batches issued at different times can also be misleading, since the batches may have been priced using entirely different old and new rates. And as covered above, FIFO can distort reported profit during inflationary periods, since issue prices lag behind current replacement costs.

FIFO and Indian accounting standards 🔗

FIFO is not just a textbook convenience. It is one of the two cost formulas actually permitted under Indian accounting rules for valuing inventory. The Ministry of Corporate Affairs’ Accounting Standard 2 on Valuation of Inventories permits the FIFO and weighted average cost formulas for goods that are ordinarily interchangeable, while LIFO is not allowed under Indian GAAP or Ind AS. This is a key reason FIFO continues to dominate Indian textbooks and corporate practice: it is not merely one option among equals, it is one of only two options a company is legally permitted to use for external financial reporting.

FIFO versus other pricing methods, briefly 🔗

It helps to place FIFO alongside its alternatives. LIFO issues the most recently purchased material first, producing the opposite cost pattern to FIFO, and is prohibited under Indian standards. Weighted average pricing recalculates a blended rate every time new stock arrives, smoothing out price swings but adding calculation work. Simple average pricing, meanwhile, ignores quantities entirely and averages only the prices, which can distort costs when lot sizes vary widely. Against these alternatives, FIFO strikes a balance: it is easier to apply than weighted averages, more defensible than simple averages, and, unlike LIFO, it is actually permitted for statutory accounts in India.

A quick worked check 🔗

Go back to the stores ledger example above. If a fourth purchase of 100 units arrives at ₹58 on the 25th, and 180 units are issued on the 28th, FIFO would issue the remaining 50 units from the 5th’s ₹55 lot first, followed by 130 units from the 15th’s ₹60 lot. The exercise of tracking which “layer” of stock is being drawn down is really the entire discipline of FIFO costing. Once a student can trace these layers confidently across several transactions, the method stops feeling like an abstract rule and starts feeling like straightforward bookkeeping.

Putting it together 🔗

FIFO earns its place in the cost accounting syllabus because it does three things well at once: it mirrors how goods physically move through most stores, it keeps closing stock valued near current prices, and it is recognised under Indian accounting standards. Its main weakness shows up during periods of rising prices, when it can make profits look better than the underlying economics justify. Students preparing stores ledger accounts should focus on tracking each purchase lot as a separate “batch” and issuing the oldest batch first, since that single habit resolves almost every FIFO problem in an exam.

What do you think? If a company’s material prices have been falling steadily for a year, would FIFO or weighted average give management a more useful picture of true production cost? And how would your answer change if the same company also had to worry about materials expiring on the shelf?

References

1. https://egyankosh.ac.in/bitstream/123456789/71359/1/Unit-5.pdf
2. https://live.icai.org/bos/vcc-3rd-batch/pdf/Chapter_2_Material_Costing.pdf
3. https://www.vskills.in/certification/tutorial/method-of-pricing-of-material-issues/
4. https://www.mca.gov.in/bin/ebook/dms/getdocument?doc=MjA0NzQ%3D&docCategory=Accounting+Standards&type=open