The FIFO method stands for “First-In, First-Out.” This inventory valuation method, which is an accounting method, assumes that the oldest inventory items are sold first. When asking what do we mean by FIFO, it’s simply that the first items to enter your inventory are the first ones to leave when sold.
FIFO means that your business sells or uses older inventory before newer inventory. This approach closely matches how most businesses naturally handle their stock, making it a practical choice for inventory management.
What is FIFO in simple words? It’s a way to track inventory where you sell your oldest products first and keep your newest products in stock.
The FIFO method is an inventory valuation method that assumes the oldest inventory items are sold first. This means the cost of goods sold is based on the cost of the oldest items in inventory.
What does acronym FIFO stand for? FIFO stands for “First-In, First-Out,” which directly describes how inventory moves through your business and is a widely recognized inventory accounting method.
FIFO is one of the most common inventory valuation methods used by businesses worldwide. It’s accepted under both generally accepted accounting principles and international financial reporting standards.
The FIFO method operates on the cost flow assumption that the cost of goods sold is the cost of the oldest inventory items. When you sell products, the cost assigned to those sales comes from your oldest inventory first.
To implement the FIFO method, you need to track when inventory items are purchased and their costs. This helps you calculate the ending inventory value and cost of goods sold.
FIFO is a straightforward inventory method that works well for most businesses. It helps you keep track of inventory costs and ensures your financial statements accurately reflect your business activities.
The FIFO method assumes that the lower-valued goods are sold first. This results in a higher valuation for ending inventory on your balance sheet.
With FIFO, your newest inventory typically stays on the balance sheet, providing a clearer picture of your current inventory value. Since newer inventory often costs more due to inflation, this leads to a more current and accurate inventory valuation.
This higher inventory valuation can improve your company’s balance sheets and minimize inventory write-offs. It makes your business look stronger to investors and lenders.
The FIFO method generally enables businesses to report higher profits and higher net income. This happens because FIFO uses older, typically lower costs for calculating cost of goods sold.
When your cost of goods sold is lower due to the associated costs of older inventory, your gross profit is higher. This flows through to your net income, making your business appear more profitable.
Higher net income can be attractive to investors and can help your business secure financing. However, it also means you’ll likely pay higher income tax.
The FIFO method is convenient because it often reflects the actual flow of inventory in many businesses. Most companies naturally sell their older stock first.
This is especially true for businesses that sell perishable goods or products with expiration dates, where sales often consist of a mix of new and older merchandise. You want to sell older inventory before it spoils or becomes outdated.
FIFO is ideal for businesses that need to use older inventory first. It aligns your accounting methods with your physical inventory management practices.
FIFO helps prevent inventory from becoming outdated by ensuring the oldest stock is always sold or used first, thus maintaining the quality of remaining stock. This approach keeps your inventory fresh and relevant.
This advantage matters most for products with shorter lifespans, like:
Seasonal items
Technology products that quickly evolve
Fashion merchandise
By maintaining a fresh inventory, you can prevent markdowns, reduce waste, and minimize the costs of holding unsellable stock. This strategy directly enhances profit margins and operational efficiency.
FIFO is essential for industries dealing with perishable items, ensuring that older inventory is sold first and maintaining the quality of sellable assets. Food, beverages, and pharmaceuticals all benefit from selling older inventory first.
Using the FIFO method for perishable goods:
Cuts down on spoilage
Maintains product quality
Helps meet health and safety regulations
FIFO is also useful for seasonal or high-turnover products. It reduces the risk of having to mark down or discard unsellable stock with limited shelf life.
FIFO provides a clear and consistent view of inventory costs by linking outgoing stock to its earliest purchase price. This method offers the most accurate approach to inventory accounting, ensuring reliable financial reporting.
With FIFO, your financial statements accurately reflect the cost of goods sold and inventory values. This helps you understand your business's profitability and make smarter choices.
During periods of inflation, FIFO often leads to higher net income. This happens because older, lower-cost items are expensed first, while newer inventory remains on your balance sheet.
The FIFO method works best when the cost of goods sold increases slightly and gradually over time, aligning with the expected cost flow. This creates a natural flow in your inventory valuation.
If suppliers suddenly raise prices of raw materials or goods, you may find significant gaps between your recorded costs and actual costs. This can distort your profit calculations.
The FIFO method is not ideal for businesses that experience sudden spikes in costs. These unexpected changes can make your financial reporting less accurate.
Because net income is usually higher for businesses using the FIFO method, they typically pay higher income tax, which can attract scrutiny from tax authorities. This is a direct result of showing lower cost of goods sold.
Higher taxes can cause cash flow issues and reduce your bottom line. You might show higher profits on paper but have less cash available.
For tax-sensitive businesses, the higher income tax from FIFO can be a significant drawback. Some companies choose alternative inventory methods to reduce taxable income.
FIFO can increase storage costs if older inventory remains unsold. When new stock arrives while existing inventory sits idle, you'll need more storage space.
Unsold products take up valuable warehouse space. The longer they sit, the more expensive it gets to store them.
For businesses managing large inventories, even a small delay in turnover can quickly drive up costs. This affects your overall profitability and warehouse operations.
To calculate cost of goods sold using the FIFO method:
Determine the cost of your oldest goods purchased
Multiply that cost by the amount of inventory sold
Repeat for each batch of inventory until you account for all sold items
The “inventory sold” refers to the cost of purchased goods or the cost of produced goods. You need to track these costs carefully.
Prices paid for inventory often change, and these fluctuating costs must be considered in your calculations. Good record-keeping is essential for implementing FIFO.
The FIFO method is not a metric that is calculated, but an approach to calculating cost of goods sold and ending inventory.
Here’s a simple FIFO calculation example:
Starting inventory: 100 units at $10 each First purchase: 50 units at $12 each Second purchase: 75 units at $15 each Units sold: 160 units
Using FIFO, the cost of goods sold would be:
100 units at $10 = $1,000
50 units at $12 = $600
10 units at $15 = $150
Total COGS = $1,750
The ending inventory would be:
65 units at $15 = $975
This shows how FIFO assigns costs based on the order of purchase, impacting the goods sold COGS.
FIFO assigns the cost of your oldest inventory items to the cost of goods sold first. Newer stock remains in inventory. During inflation, this method typically leads to lower cost of goods sold.
LIFO (Last In, First Out) works differently, assigning the cost of your newest inventory to COGS first. This typically results in higher COGS and lower taxable income during inflation.
FIFO helps businesses minimize product waste and maintain high-quality inventory, particularly for perishable items with limited shelf life. Unlike LIFO, this method better reflects how most companies actually move their stock.
FIFO provides a clearer picture of inventory value and keeps financial statements more aligned with current market conditions. The LIFO method is not allowed under international financial reporting standards.
The average cost method uses an average cost for every inventory item when calculating COGS and ending inventory value, unlike specific inventory tracing which tracks individual item costs. This smooths out price fluctuations.
The FIFO method doesn’t use averaging but assigns a specific value to every unit of inventory based on when it was purchased. This creates a more precise tracking system.
The choice between FIFO and average cost impacts:
Your cost of goods sold
Ending inventory value
Reported profit
Tax obligations
Each method has advantages depending on your business type and sales patterns.
An AS/RS can help with first in first out warehousing by automatically storing and retrieving loads, ensuring the successful implementation of FIFO. This system ensures older inventory is picked first.
Benefits of AS/RS for FIFO:
Minimizes manual intervention
Enhances tracking and data analytics
Improves warehouse management
Reduces workplace accidents
However, an ineffective system can lead to damaged goods or high costs. Make sure to choose a system that fits your specific inventory needs.
A pallet racking system designed for FIFO warehouse management helps ensure that the oldest pallet is always the first one removed, supporting your supply chain efficiency. This supports your inventory method with physical organization.
Pallet flow rack systems use tracks or rollers to move packages from the loading side to the unloading side. This creates a natural first-in, first-out flow.
These systems can be customized for specific speeds and product loads to maximize efficiency. They work well for businesses dealing with perishable goods or items with expiration dates.
While pallet flow rack systems require investment, they can provide a high return by reducing waste and improving inventory accuracy.
Stock mismanagement is a risk, especially if newer products are easier to access than older ones, affecting how a company sells its inventory. Without proper systems, employees might grab the most convenient items rather than the oldest.
When inventory isn’t rotated properly, older items can be overlooked, leading to:
Waste and spoilage
Outdated products
Inventory write-offs
Lost revenue
To avoid these problems, train your staff thoroughly and implement clear procedures for inventory handling.
During inflation, FIFO (First-In, First-Out) accounting can inflate profits. This method uses older, cheaper inventory for cost calculations, which makes earnings look better than they are. Recent inventory typically costs more, but the cost of goods sold doesn't capture these higher current replacement costs.
This can lead to paying higher taxes, which can be a challenge for businesses with tight margins. You might show strong profits but struggle with cash flow issues.
Be aware of this limitation when analyzing your financial performance. Consider the impact of inflation when making business decisions based on FIFO-calculated profits.
Tyre manufacturing requires high-quality rubber as the main ingredient. This makes it a perfect example of where the FIFO method is valuable.
Rubber has a limited shelf life and can degrade if not stored properly. This affects the quality of the final product and can lead to waste.
Raw rubber can be stored for several months, but rubber compounds have a shorter shelf life of 5-28 days, depending on storage temperatures. Using the oldest components first is essential.
Vulcanized tyres have a shelf life of approximately 20 years. Even with this extended timeframe, using FIFO helps ensure customers receive the freshest possible products and accurate financial reporting at the end of each accounting period.
FIFO is particularly useful in these industries:
Food and beverage - where expiration date management is critical
Apparel - where styles change seasonally
Pharmaceutical - where products have strict expiration dates
Electronics - where technology quickly becomes outdated
Ecommerce business - where inventory management is critical
Companies that export goods also use FIFO to comply with international financial reporting standards, which don’t allow LIFO.
FIFO helps businesses use warehouse space more effectively, save on labor costs, and minimize wear and tear on equipment. It’s a practical approach for most business types.
FIFO helps businesses reduce waste by moving older stock first. This approach lowers the risk of spoilage and keeps product quality high. It works especially well for companies selling perishable goods.
By consistently using older inventory first, you:
Minimize expired products
Reduce markdowns on outdated items
Improve overall inventory quality
Maintain customer satisfaction
FIFO is especially effective for managing perishable items or products with expiration dates. It helps you sell products while they’re still at peak quality.
Keep in mind that for food products, a WMS that allows for lot number tracking and follows FEFO (first expiration, first out)rules is the better choice to avoid losses and manage perishable goods effectively.
Inventory turnover measures how quickly you sell and replace inventory. A higher turnover rate usually indicates better sales and inventory management.
When using the FIFO method, compare your inventory turnover with industry benchmarks to understand if your total inventory management is effective. This helps you understand if your inventory management is effective.
Best practices for improving inventory turnover with FIFO include:
Accurate demand forecasting
Just-in-time ordering
Regular inventory audits
Clear warehouse organization
Employee training on FIFO procedures
By improving your inventory turnover, you can reduce carrying costs and increase profitability.
The FIFO inventory method is simple and mirrors the natural flow of goods in most businesses. It creates a logical system where older inventory is sold first.
FIFO helps businesses minimize waste and prevent product spoilage. By using this method, companies can track and use items before they expire. It works best for perishable goods and time-sensitive products.
It brings financial clarity, with older costs directly tied to cost of goods sold. This creates accurate financial reporting that helps you make better business decisions.
What is FIFO at work? It's a practical approach to inventory management that benefits most businesses by aligning accounting methods with physical inventory flow.
FIFO stands for "First-In, First-Out" and represents both an inventory valuation method and a physical inventory management system. By implementing FIFO in your business, you can improve accuracy, reduce waste, and enhance customer satisfaction.