For thousands of businesses, the first in, first out (FIFO) method represents the ideal means for tracking inventory, mitigating product damage, and reducing spoilage-related losses.
As the name suggests, the FIFO periodic inventory method involves selling or using the oldest assets first. So you use or sell goods in the order you acquire them.
What does FIFO require in terms of implementation? We’ll answer that and more so you can take advantage of this efficient and highly practical inventory accounting strategy.
What is the FIFO method?
FIFO stands for first in, first out. It’s both a stock rotation strategy used to manage goods and an inventory valuation method used to calculate cost of goods sold (COGS).
As a stock rotation strategy, using FIFO means always moving the oldest inventory out first. So, you sell or use the items you received or produced the earliest before turning to newer stock. This helps you maintain product freshness and reduce the risk of holding outdated or expired goods that tie up storage space and working capital.
On the accounting side, when you use FIFO, you assign the cost of your oldest inventory to items sold first. Older inventory usually costs less due to factors like inflation, so FIFO often results in a lower COGS. This gives you a clearer picture of your profits and current inventory value.
How the FIFO method works
The FIFO method formula is pretty simple. When you receive new items, you put them at the bottom of your inventory list or the back of a stockroom.
Think of a grocery store clerk restocking milk. They don’t put the new stock at the front of each row. Instead, they place incoming stock at the back, which pushes older cartons to the front. The goal is to prevent spoilage and ensure the older units sell before those with a longer remaining shelf life.
The FIFO method is one of the most effective inventory planning and management strategies for the food and beverage space. However, most product-focused teams can benefit from the first in, first out approach — even if they don’t deal in perishable products.
To leverage this method, you need to maintain detailed records of each product’s entry and exit dates. While you could track these dates manually, doing so would create more problems than it would solve. Instead, consider adopting an inventory management solution compatible with the FIFO accounting method.
Implementing FIFO in warehousing
Applying the FIFO warehousing strategy all starts with the right equipment.
A gravity flow racking or pallet rack system is essential. These systems let your teams feed goods into one side of the rack and retrieve them from the other, much like the store shelves that hold cartons of milk and other perishables.
You also need to train your staff in the first in, first out principle. While the approach is relatively simple, it can take some time for your team to get accustomed to the new stocking strategy.
Perhaps most importantly, you need dynamic inventory management software that tracks product entry and exit dates. Otherwise, you’ll have to record all those dates manually, greatly increasing the chance of accounting errors.
Integrating an industry-leading inventory management platform will pay dividends for your business. The top options assist with everything from average inventory accounting to tracking losses and running analytics reports. You’ll also be able to hold inventory, keep up with stock levels, and tailor your reordering strategy.
Example of using FIFO
The FIFO calculation reveals your COGS.
To calculate COGS, you need to know two things: the cost of your oldest inventory and the amount of inventory sold. The cost of inventory sold refers to either the cumulative costs of producing goods, which includes labor, materials, and overhead, or the cost of purchasing finished products you intend to resell.
Say you purchase 100 units of a product in two batches of 50. The first 50 units cost $10 each, and those in the second batch cost $15. Batch one’s 50 units are the oldest and have already sold. The second set of 50 units hasn’t sold yet, which means you can’t use them in your COGS calculation.
Using the FIFO calculation formula, multiply the amount of inventory sold (50 units) by the cost of those units ($10 each). The formula will appear as follows:
COGS = $10 x 50
COGS = $500
Once you determine COGS, you can make other calculations to define critical operational metrics like gross revenue and net profits.
Alternative inventory valuation approaches
FIFO is a popular valuation method because it’s simple, logical, and aligned with International Financial Reporting Standards (IFRS). But it’s not the only approach out there — here are a few alternatives, each with their own pros and cons:
- LIFO (Last In, First Out): LIFO is the opposite of FIFO; you account for the newest inventory first. As a result, your COGS is higher, which lowers your net income — and therefore your taxes — for the accounting period. This is helpful when operation costs are high (for example, due to inflation). However, LIFO isn’t accepted under IFRS.
- WAC (Weighted Average Cost): With this method, you divide the total cost of all goods for sale by the total number of units to find the average cost per inventory unit. This simplifies your accounting, but it can mask price fluctuations and reduce pricing precision.
- Specific identification: This approach tracks the exact cost of each inventory item and assigns it to COGS as items are sold. It’s ideal for high-value, low-volume products like cars or luxury goods. But it requires meticulous tracking, which makes it impractical for businesses managing large volumes of inventory.
The advantages of using the FIFO method
While this method is popular among food and beverage brands for reducing spoilage risk, that’s just one of its many business benefits.
By adopting a FIFO approach, you can sharpen your profit and COGS calculations, reduce losses, and unlock actionable insights regarding product demand. Let’s unpack some of these potential advantages.
Compatibility with updated business systems
Most modern inventory management technologies support the first in, first out method, while few platforms support more complex strategies.
Additionally, configuring your software to align with the FIFO method is quick and easy due to the strategy’s simplicity, meaning you’ll enjoy a stronger return on investment and condensed time to value.
Purchasing new inventory software is a significant (albeit worthwhile) investment. You don’t want to wait months to see benefits like cost savings and efficiency gains. FIFO’s simplistic nature means you’ll achieve the business improvements you’re after sooner rather than later due to an easy learning curve and seamless adoption process.
Precision in profit margins
The costs of goods and materials change over time, and when you use other accounting methods, newer and more costly products might not sell before older stock. If old and new stock sell in the same order, it becomes difficult to accurately track profits and COGS.
Let’s revisit the example above. Instead of selling all 50 units with a cost of $10 each, imagine you sell 30 units with a cost of $10 each and 20 units with a cost of $15 each. At first glance, running the COGS calculations might not seem all that complicated. However, you have to bear in mind that the accounting system will not care about the actual cost of each item. Under the FIFO inventory valuation method, it will simply record the first 50 units that are sold as all having the same cost ($10). And the next 50 that are sold will have the $15 cost assigned to them, no matter their true cost.
The FIFO method helps mitigate those complications and maintain accounting accuracy. As a result, you gain a better understanding of your profit margins.
Enhanced business value for potential buyers
As the cost of goods inclines over time, the FIFO method ensures you sell the oldest stock first, helping balance your COGS in relation to your profits.
And if you’re seeking investor support or aspire to sell your company, the FIFO method helps you demonstrate a better value. When reviewing your sales, COGS, and revenue data, investors will see a trend of rising prices and profits consistent with increasing back-end costs.
Limitations of using FIFO
While FIFO offers many benefits, it also has some drawbacks. Understanding these can help you decide whether FIFO is the right fit for your company.
Higher tax liability
Since your COGS is typically lower with FIFO, your reported profits trend higher. This enhances the value of your business, which is good for investors and stakeholders, but it also increases your taxable income. As a result, your tax liability is higher, which can limit your cash flow and your ability to reinvest funds in the company’s growth.
Higher tax liability is especially troublesome when inflation is high. As the cost of replacing inventory rises, you’re paying tax on earnings that don’t fully reflect your current expenses. This can further squeeze your cash flow, making it harder to cover rising operational costs and invest in new opportunities.
Complex implementation
Accurate FIFO tracking requires detailed record-keeping. To know which inventory is oldest, you need to keep track of purchase dates and quantities for each SKU. If your inventory is particularly large or fast-moving, staying on top of this data can be time-consuming.
This complexity becomes manageable with the right inventory management solution. Software like Fishbowl can automate FIFO tracking, helping you maintain accurate costing data without headaches.
Poor fit in certain industries
FIFO is helpful for businesses selling perishable goods, but other industries may find it less effective. Take the electronics sector. Tech products can fluctuate in value based on demand, trends, and model upgrades, so it’s not always ideal to push out the oldest stock first. The same may apply to businesses selling hardware, machinery, furniture, or luxury items.
These industries can still use FIFO for accounting, but this may add complexity. When older stock doesn’t match current market prices, FIFO can overvalue inventory and distort profit margins. Alternative methods like LIFO or WAC might offer a more realistic view of your finances.
FIFO versus LIFO
The LIFO and FIFO methods are complete inverses. With the LIFO method, you sell the newest stock first.
Each method affects financial statements and inventory valuation in opposite ways, especially under varying market conditions. For instance, LIFO can be more beneficial during times of inflation because selling the newest inventory first lowers your net profits and, in turn, your taxable income. Conversely, FIFO is more advantageous when prices are stable or declining. Understanding these nuances is crucial for selecting the right inventory method for your business.
Thus, when costs are rising, LIFO generally results in higher cost of goods sold and lower taxable income.
3 FIFO implementation best practices
The following best practices about inventory flow, shipment tracking, and management systems will ease your team’s transition to the FIFO method.
1. Monitor inventory flow
Regularly analyze the movement of goods in and out of your facility to ensure your team adheres to FIFO protocols. Implementing automated product-tracking tools helps you keep up with product receipt dates and determine whether you’re deviating from the approach.
While a few minor deviations likely won’t hurt your profitability, it’s essential to identify and resolve issues quickly. Otherwise, your COGS calculations will be inaccurate, and you may under or overestimate profits.
2. Record inventory immediately
Prompt and accurate recording of new stock means you’ll know when every lot number enters and leaves your facility.
However, recording inventory manually is tedious, labor-intensive, and inefficient. That’s why it’s wise to adopt an inventory management solution with automation functionality.
3. Use inventory management software
Regarding software, remember that not all platforms are created equal. Solutions like Fishbowl are configurable and user-friendly, helping you implement FIFO inventory accounting to significantly improve stock visibility.
That’s not all — Fishbowl is loaded with tools designed to make your life easier. Some of the most useful include reporting capabilities, automation features, and a no-nonsense interface that provides real-time insights into the state of your business.
Fishbowl is the first inventory software for your FIFO needs
Fishbowl streamlines operations with a seamless QuickBooks integration. Whether using the FIFO inventory method or another strategy, Fishbowl ensures accurate tracking and efficient inventory management. Check out the warehousing solution to experience the power of Fishbowl’s comprehensive inventory solutions.