FIFO Method Explained: First-In, First-Out Inventory Management

Rohit Rajpal

Senior Writer

what is the fifo method a detailed guide

Efficiency is doing things right. Effectiveness is doing the right things. – Peter Drucker

FIFO (First-In, First-Out) aligns with this principle by serving as a critical framework in inventory management and accounting. It plays a crucial role in various industries, from retail to manufacturing, and helps businesses accurately track their stock movement and financial performance.

leftarrow imageLooking for Inventory Management Software? Check out SoftwareSuggest’s list of the best inventory management software solutions.

FIFO affects financial reporting, taxes, and operational efficiency. Managers, accountants, and business owners benefit from mastering FIFO to optimize inventory systems and financial practices. 

But what is the FIFO method? Let’s understand in detail along with a FIFO example.

protip image
Pro-tip

When implementing FIFO, create a robust system that aligns your physical inventory with your digital records. Invest in quality inventory management software, train your staff thoroughly, and conduct regular audits. Consistently review and refine your processes to adapt to changing business needs and market conditions.

What Is First In, First Out (FIFO)?

FIFO method assumes that the earliest acquired items are the first to leave inventory, regardless of their actual usage order. The FIFO inventory valuation method is widely applied across industries, particularly when managing goods with short shelf lives or rapidly evolving technologies.

It helps businesses accurately track inventory costs, calculate profits, and manage stock levels. The FIFO inventory method has significant effects on company financial reports, tax filings, and strategic choices. It can lead to higher reported profits during inflation periods, as older, less expensive inventory is expensed first while newer, potentially pricier items remain in stock.

How Does the FIFO Method Work?

As mentioned above, the FIFO method operates on a simple principle: the first items to enter inventory are the first ones sold or used. It closely mirrors the natural flow of inventory in many businesses.

how does the fifo method work? by softwaresuggest

Here’s how it works in practice.

  1. Inventory tracking: Companies maintain detailed records of when items are purchased or produced, along with their costs.
  2. Sales calculation: When a sale occurs, the cost of the oldest inventory items is used to calculate the cost of goods sold.
  3. Remaining inventory: Newer inventory items, potentially with different costs, remain in stock for future sales.
  4. Financial reporting: The cost of goods sold reflects older inventory prices, while the remaining inventory value on the balance sheet represents more recent costs.

When to Use the FIFO Inventory Method?    

The FIFO inventory method is ideal in several business scenarios:

  • Perishable goods: Industries dealing with food, pharmaceuticals, or other items with limited shelf life benefit from FIFO’s logical flow.
  • Fashion and technology: Sectors with rapid product turnover use FIFO to accurately reflect the cost of newer, potentially more expensive items in inventory.
  • Inflationary economies: FIFO can be beneficial in industries experiencing rising prices as it typically results in lower reported expenses for goods sold and higher profit figures.
  • Simplicity in tracking: For businesses seeking a straightforward inventory valuation method, FIFO offers ease of implementation and understanding.
  • Financial statement accuracy: FIFO often provides a more current and accurate representation of inventory value on the balance sheet.

Advantages of the FIFO Method

The top four advantages of the First in, First out inventory method are its ability to provide accurate profit margins, simplify cost calculations, align with international standards, and maintain up-to-date inventory data. Let’s understand these in detail.

top benefits of the fifo method by softwaresuggest

1. Accurate Profit Margins

FIFO provides a more realistic representation of profit margins, especially in industries with fluctuating prices. It matches current sales prices with historical costs, reflecting actual profit per sale. Precise inventory tracking also allows companies to determine which products generate the most profit, adjust prices effectively, and make smart choices about which items to stock and invest in.

2. Simplified Cost Calculation

The FIFO method’s logical approach to inventory flow makes cost tracking and calculation easier. This simplicity reduces accounting errors, speeds up month-end closings, and streamlines audits. The simplifies onboarding for new employees and streamlines accounting processes, which reduces overall operational expenses.

3. Alignment with International Standards

First in, First out inventory method is compliant with IFRS and GAAP, which makes it ideal for companies with global operations or aspirations. This ensures consistent financial reporting across different countries, facilitates easier comparisons with competitors, and can improve a company’s credibility with international investors and partners. It also simplifies the process of mergers, acquisitions, or entering new markets.

4. Up-to-date Inventory data

By assuming older stock is sold first, FIFO ensures the balance sheet reflects more recent purchase prices in inventory valuation. This offers a more precise valuation of current stock levels and enhances the accuracy of financial ratios and forecasts. It also aids in better inventory management by helping businesses make more informed decisions about restocking, pricing, and product lifecycle management.

Disadvantages of the FIFO Method 

The FIFO method, while beneficial in many scenarios, does have some drawbacks. Here are the key disadvantages of the FIFO method.

drawbacks of the fifo method by softwraesuggest

1. Higher Taxes in Inflation

In times of rising prices, FIFO results in higher reported earnings because it pairs current sale prices with inventory purchased at earlier, lower costs. This increased profit results in higher tax liabilities. Companies may find themselves paying more in taxes without a corresponding increase in cash flow, potentially straining their financial resources.

2. More complicated than LIFO

While FIFO is generally straightforward, it can be more complex to implement than LIFO (Last-In, First-Out) in certain situations. FIFO requires detailed record-keeping of purchase dates and costs for each inventory batch. The complexity increases administrative overhead and introduces a higher risk of errors in inventory valuation and financial reporting, especially for businesses with large, diverse products or frequent stock turnover.

3. Unfit for price volatility

First in, First out inventory method is ill-suited for industries with highly volatile prices, such as commodities (oil, gold, agricultural products), technology (computer chips, electronic components), and fashion. In these sectors, rapid price fluctuations can lead to a significant mismatch between reported profits and actual inventory replacement costs.

For instance, during a sharp rise in oil prices, an energy company using FIFO might report artificially high profits as sales are matched with older, cheaper inventory. This discrepancy can result in misleading financial statements that don’t accurately reflect the company’s true financial position or operational challenges.

How Is the FIFO Method Calculated?

The FIFO method calculates inventory costs by assuming that the oldest items are sold first. Here’s the basic formula.

FIFO Method Formula

Ending Inventory Value = Ending Inventory Value = (Remaining Units × Their Respective Purchase Costs)

The method for calculating the final inventory value remains consistent across different accounting approaches. Use this formula to determine the ending inventory.

COGS = (Units Sold × Cost of Oldest Inventory) + (Remaining Units × Cost of Next Oldest Inventory)

To explain how FIFO works in practice, let’s consider an example of a small bookstore managing its inventory of bestselling novels over a quarter:

Inventory Purchases

  • April 5: 300 books at $15 each (Total: $4,500)
  • May 20: 250 books at $16 each (Total: $4,000)
  • June 15: 400 books at $14 each (Total: $5,600)

Sales: 500 books sold at $25 each (Total Revenue: $12,500)

COGS Calculation

  • 300 books from April 5: 300 × $15 = $4,500
  • 200 books from May 20: 200 × $16 = $3,200
  • Total COGS: $4,500 + $3,200 = $7,700

Ending Inventory

  • 50 books from May 20: 50 × $16 = $800
  • 400 books from June 15: 400 × $14 = $5,600
  • Total ending inventory value: $800 + $5,600 = $6,400

Best Practices for Implementing FIFO

Implementing the First-In, First-Out (FIFO) method effectively can significantly improve your inventory management and financial reporting. Here are key best practices to ensure successful implementation of the FIFO inventory valuation method.

best practices for implementing fifo-successfully by softwaresuggest

1. Accurate Record-Keeping

Accurate record-keeping ensures that you have a clear, real-time understanding of your inventory levels, costs, and movements. Without precise records, it’s impossible to correctly apply FIFO principles, which can lead to errors in financial reporting and inventory valuation.

Here are some tips to maintain accurate records.

  • Implement a robust inventory management system to track all purchases and sales.
  • Document key information for each inventory item, including purchase date, quantity, and price.
  • Utilize barcode scanners or RFID systems to automate data entry and minimize errors.
  • Regularly reconcile digital records with physical inventory counts.
  • Educate staff on the importance of accurate data entry and proper inventory record-keeping.

2. Physical Organization of Inventory

Organizing your physical inventory makes it easier to ensure older stock is used or sold first. This reduces the risk of inventory obsolescence, minimizes waste for perishable goods, and helps maintain consistency between your physical stock and accounting records.

Follow these four steps to organize your inventory.

  • Arrange storage areas with clear “first in, first out” lanes or shelving.
  • Use a “two-bin” system where possible, refilling the front bin only when it’s empty.
  • Implement clear labeling systems, including purchase dates or expiration dates.
  • Conduct regular audits to ensure physical organization aligns with FIFO principles.

3. Invest in Staff Training and Education

FIFO is only effective if everyone involved in inventory management understands and follows the principles consistently. Effective training aligns staff practices, reduces mistakes, and improves overall inventory accuracy.

Here are some tips.

  • Develop comprehensive training materials explaining FIFO principles and their importance.
  • Implement regular training programs for both new team members and long-term employees to keep skills up-to-date.
  • Incorporate real-world scenarios and interactive learning exercises to illustrate how FIFO operates in daily business situations.
  • Create an environment that welcomes questions and offers continuous guidance to resolve any confusion.
  • Create easily accessible reference guides for common FIFO-related tasks.

4. Conduct Regular Inventory Audits

Regular audits help identify discrepancies between recorded inventory and physical stock. They’re crucial for maintaining the accuracy of your FIFO system, catching errors early, and ensuring that your financial reporting reflects reality.

Here’s how to effectively conduct inventory audits.

  • Schedule regular full inventory counts (e.g., annually or semi-annually)
  • Implement cycle counting for ongoing partial inventory audits
  • Use barcode scanners or RFID technology to speed up the counting process
  • Compare physical counts to system records and investigate any discrepancies
  • Use audit results to improve processes and identify areas for additional staff training

5. Integration with Accounting Systems

Seamless integration between inventory management and accounting systems ensures FIFO calculations are correctly reflected in financial reports. This provides real-time cost of goods sold figures, improves the accuracy of profit calculations, and simplifies the financial reporting process.

Follow these five steps to ensure proper integration.

  • Select inventory management software that works well with your existing accounting system.
  • Set up automated data transfers between systems to reduce manual entry errors.
  • Configure your systems to calculate COGS using FIFO principles automatically.
  • Regularly reconcile inventory valuations between systems to catch any discrepancies.
  • Work with your accounting team to ensure they understand how FIFO data flows into financial reports.
Suggested Read:

Conclusion

The FIFO method offers accuracy in profit margins, simplifies cost calculations, aligns with international standards, and provides up-to-date inventory data. While it may lead to higher taxes during inflation and struggle with price volatility, its benefits often outweigh these inventory challenges.

When properly implemented, FIFO helps companies streamline their inventory processes, enhance decision-making, and maintain clear financial records. Successful implementation of the FIFO method requires accurate record-keeping, physical organization of inventory, staff training, regular audits, and integration with accounting systems.

Frequently Asked Questions

FIFO impacts financial statements by typically reporting higher profits during inflation. It results in lower cost of goods sold and higher ending inventory values on the balance sheet. This method often leads to more current inventory valuation and can affect key financial ratios used by investors and analysts.

FIFO operates on the principle that older stock exits first, while LIFO assumes newer items are sold before older ones. During inflationary periods, FIFO typically shows lower costs and higher profits, whereas LIFO often results in higher costs and lower profits. FIFO usually aligns more closely with the actual movement of goods in most businesses.

Alternative methods include LIFO, Weighted Average Cost, Specific Identification, and Standard Costing. LIFO assumes the newest inventory is sold first, resulting in a higher cost of goods sold during inflation. Weighted Average Cost averages prices across all units. Specific Identification tracks individual item costs, while Standard Costing uses predetermined values while adjusting for variances over time.

Businesses in industries with rising costs or prices typically use the LIFO method. This includes companies dealing with commodities, such as oil and gas firms, or those with inventory that doesn’t deteriorate, like metal or chemical producers. LIFO can offer tax benefits when prices are rising by showing reduced profits on paper.

Rohit
About the author

Rohit Rajpal is an accomplished writer with a deep understanding of technology, digital marketing, and customer service. He brings extensive expertise in ERP and CRM systems, blending technical insight with clear, engaging content. Rohit’s work bridges the gap between complex concepts and accessible communication for diverse audiences.

knowledge image
Your Business Deserves Better Software!

Upgrade your business operations with modern software solutions tailored to your needs.

subscribe image
Let’s Stay in Touch

Subscribe to our newsletter & never miss our latest news and promotions.

people subscribed+21K people have already subscribed 
Related Articles
sitemap
Share This