What Is First In, First Out (FIFO)?
First In, First Out (FIFO) is a method of inventory valuation where it's assumed that the oldest units of inventory are sold first. Other widely used inventory costing methods are Last In, First Out (LIFO) and weighted average cost.
However, LIFO is only used in the United States as allowed by Generally Accepted Accounting Principles (GAAP); the International Financial Reporting Standards (IFRS) Foundation doesn't allow businesses to use LIFO. The IFRS wants to ensure that financial statements are consistent, transparent, and comparable around the world.
Why is there so much discussion around inventory? If you have a product-based business, such as retail or manufacturing products, inventory is your biggest asset. You can only get your money back and make a profit when you sell your stocks. That's why effective inventory management is vital for running and growing your business.
What Is FIFO Inventory Management?
First In, First Out (FIFO) is an inventory management and valuation method where raw materials and goods produced or bought first are sold, used, or disposed of first. For inventory accounting and tax purposes, FIFO assigns the cost of the oldest inventory for the cost of goods sold (COGS) in the income statement. The remaining stock is priced according to the cost of the most recent inventory purchases.
Accounting for and accurately valuing inventory is important in ensuring your company's financial statements are precise and true to IFRS and GAAP standards. For FIFO, you assign the cost of sales based on the inventory that arrived first.
For example, if you have a retail store selling handmade soaps and bought 100 lavender soaps for $20 and then purchased 100 more for $15, you would assign the cost of the first item resold as $20 with FIFO. After you sold 100 soaps, you would then use $15 as the cost of each soap resold, even if you made additional inventory purchases for higher or lower prices.
The FIFO method follows the logic that to avoid obsolescence — such as expired or stale products — a company should sell or use the oldest inventory items first.
What Is the Difference Between the FIFO and LIFO Methods?
Here are the main differences between the FIFO and LIFO methods:
- The FIFO method assumes that the oldest unit of inventory is sold or used in production first.
- The LIFO method assumes that the newest stock or last unit to arrive in inventory is sold or used in production first.
- The FIFO method is allowed by both GAAP and IFRS.
- The LIFO method is practiced in the U.S. only, as it's allowed by GAAP. It's not recognized in other countries because IFRS prohibits it.
- The FIFO method is a logical practice for companies that don't want to use spoiled or expired goods in their production or selling.
- The LIFO method is a practice that may apply to businesses with nonperishable goods only.
What Are the Benefits of FIFO?
Inventory accounting can be a daunting task, but it's an essential aspect of owning a product-based business. The inventory valuation and accounting methods you use and how well they're implemented are part of your company's foundation. They'll also provide you with useful insight into the overall performance and growth of your business.
To get a better sense of the FIFO method, let's dive into its benefits.
Global Acceptance and Usage
FIFO is accepted and easily understood by stakeholders — investors, buyers, and other businesses worldwide. It's in keeping with the IFRS. If your company does business outside of the U.S., you won't have to explain or defend it as an inventory valuation method.
Easy to Understand
The cycle and cost flow of inventory items under FIFO is logical and reasonable for businesses to follow. With FIFO, business owners or employees are expected to use raw materials for production or display merchandise to be sold from oldest to newest. It's a simple system to practice.
More Accurate Inventory Valuation
Since FIFO assigns the price of the oldest stocks to calculate the COGS, the cost of on-hand inventory is valued using the price of the items purchased recently. This results in a more accurate inventory valuation tied to current market prices. (This also explains why the FIFO method is said to be a better indicator of the value for ending inventory.)
Minimal Inventory Losses
With FIFO, your oldest stock (first in) gets sold first (first out). The method is good in theory, but it's even better when you put it into practice. Using or selling the oldest stocks first creates a more intuitive flow of products and minimizes losses from obsolete, spoiled, or expired goods.
Higher Profit Odds
With FIFO, the possibility of higher gross income is greater because the COGS is calculated using the price of the oldest inventories, which generally have lower costs. Market prices fluctuate, but they go up more than they go down. This is why FIFO is said to give a clearer picture of a business's profitability and growth.
What Are the Disadvantages of FIFO?
While there are numerous advantages to the FIFO method, there are also some disadvantages, including but not limited to:
Misleading Financial Statements
The FIFO method may not accurately represent current market costs during periods where prices are increasing quickly. Inventory is valued from the oldest stocks, which may have been purchased months or even years ago. Businesses using the FIFO cost method report COGS that may not reflect current market prices when releasing financial statements, which could be construed as misleading.
Higher Income Taxes
The most significant disadvantage of the FIFO method is the resulting higher tax liability from higher gross income. Because the COGS is valued from generally lower market prices, the result is a higher gross income than if the company used the LIFO method. A higher tax liability means more cash outlay for the business.
What Is an Example of FIFO?
To illustrate how the FIFO method works, let's calculate the total goods available for sale, cost of goods sold, and the ending inventory balance of a retail store selling handmade soaps in its first year of operations. Here are all of the purchases the business made during the year:
|Purchases||Amount||Unit Cost||Total Cost|
- Total purchases, or the cost of goods available for sale, are $63,125 for the year.
- A total of 10,000 units were sold for the year.
We'll take the cost per unit of the oldest inventory first and make our way up to the most recent stocks and allocate the COGS for 10,000 units.
|3,500 x $3.00||= $10,500|
|2,000 x $4.00||= $8,000|
|3,000 x $4.25||= $12,750|
|1,500 x $4.75||= $7,125|
|Total cost||= $38,375|
Under the FIFO method, the company's COGS amounts to $38,375. The on-hand inventory reported on the balance sheet would then be $24,750.
|=||Goods Available for Sale - COGS|
|=||$63,125 - $38,375|
Keep Track of Your Inventory Using Skynova
Choosing the right inventory valuation method for your business is important. It impacts the calculation of the COGS and ending inventory, which ultimately affects your net income and tax liabilities. It's also worth noting that you would have to file Form 970 if you want to switch from the FIFO method to the LIFO method.
Track your sales and invoices with Skynova's all-in-one invoicing and accounting software for small business owners. When you keep accurate records of your income and expenses, you can easily make better projections for your inventory needs. Generate financial statements with Skynova's accounting software and monitor your company's cash flow, growth, and profitability.
You're welcome to explore Skynova's platform — you'll find business templates, software products, and articles to help you run and grow your business.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're using an inventory valuation method best suited to your business.