FIFO Method & Cost Basis

by Eric Bank

Cost basis is the amount of money you spend on an asset before you sell it. If you buy or make many units of these assets at different prices and then sell some of them, your income and income tax will depend on which cost bases you use for the sold items. From the perspective of a business, the assets might be inventory; for individuals or businesses, they might be investments.

Inventory Cost Basis

Under the Internal Revenue Service uniform capitalization rules, you need to include direct and certain indirect costs when figuring the cost of goods sold, or COGS, for inventory items. Direct costs are ones you can directly tie to an inventory item. They include the wholesale cost of merchandise and the materials and labor used to manufacture inventory for sale. According to the IRS, you must also include certain other costs in COGS, including containers and packages that are integral to inventory items, freight-in charges and an allocated portion of overhead expenses that are necessary to create or store the inventory. The IRS gives the following examples of allocable overhead expenses: “rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor, and supervision.”

First In, First Out

When you sell inventory, you need to make an assumption about the cost bases to use in COGS in order to figure your gross profit -- the sale proceeds minus the COGS. In the first in, first out, or FIFO, method, you use the oldest inventory costs first. For example, if you purchased two lots of identical merchandise, you would apply the cost basis of the older lot to COGS first. In times of rising costs, FIFO will normally create the largest gross profits, since the oldest cost bases are the lowest. Under these circumstances, your tax bill will be higher than had you used an alternative cost flow method, such as last in, first out, average cost or specific identification. The reverse is true in times when costs are falling.


FIFO is also one of the cost flow methods you can use to figure capital gains and losses on financial investments such as stocks, bonds, options and mutual funds. The cost basis of an investment includes the purchase price as well fees, commissions and any other costs necessary to the purchase. Your broker or mutual fund company records each separate purchase transaction in a “tax lot” that includes the cost basis of the purchase. If your broker or fund, either through default or because of your explicit instruction, uses the FIFO method, then the cost basis of the sold securities contains the oldest tax lots first. In rising markets, this will create the largest capital gain and thus the largest tax bill.

Investment Considerations

Investments that use the FIFO method are the most likely to create long-term capital gains and losses. The IRS offers a tax break for long-term capital gains; these apply to securities you hold for more than one year. Your broker or fund report capital gains and losses to you and the IRS on Form 1099-B. The form contains the cost basis for all investments made on or after Jan. 1, 2011. You will have to supply the cost basis on sales of securities you purchased before that date. Morningstar reports that an informal survey of brokers reveals that most use FIFO as their default method for determining cost basis.

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