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.
Key Takeaways
- FIFO (first in, first out) is both a stock rotation strategy that sells oldest inventory first and an accounting method that assigns older costs to COGS, typically resulting in lower reported expenses and higher taxable income.
- Implementing FIFO in warehousing requires gravity flow or pallet rack systems, staff training, and inventory management software that tracks product entry and exit dates automatically.
- FIFO works best for perishable goods and stable or declining price environments, while industries with fluctuating product values like electronics may benefit more from LIFO or weighted average cost methods.
- To calculate COGS using FIFO, multiply the quantity of inventory sold by the cost of your oldest units—for example, selling 50 units at $10 each equals $500 in COGS.
What Is the FIFO Method?
FIFO (first in, first out) is an inventory management approach where you sell or use the oldest stock before newer stock—and an accounting method where you assign the cost of your oldest inventory to items sold first. It serves two distinct purposes in your operation:
- Stock rotation strategy: You move the oldest inventory out first, maintaining product freshness and reducing the risk of holding expired goods that tie up storage space and working capital.
- Inventory valuation method: You assign older (typically lower) costs to items sold first, which often results in lower COGS and a clearer picture of your profits.
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 place incoming stock at the back, pushing older cartons to the front. The goal is to prevent spoilage and ensure older units sell before those with 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 requires three core components:
- Proper racking equipment: Gravity flow or pallet rack systems let your teams feed goods into one side and retrieve them from the other, ensuring oldest stock moves out first.
- Staff training: While the approach is relatively simple, it can take time for your team to get accustomed to the new stocking strategy.
- Inventory management software: Dynamic software that tracks product entry and exit dates eliminates manual recording and reduces accounting errors.
Integrating an industry-leading inventory management platform will pay dividends for your business. The top options help you:
- Perform average inventory accounting and track losses
- Run analytics reports
- Hold inventory and keep up with stock levels
- Tailor your reordering strategy
Example of Using FIFO
The FIFO calculation reveals your COGS.
To calculate your cost of goods sold, 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 is your ending inventory and can’t be used 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.
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 at $10 each, imagine you sell 30 units at $10 and 20 units at $15.
At first glance, the COGS calculation seems straightforward. However, the accounting system doesn’t track actual cost per item—under FIFO, it records the first 50 units sold at $10 each, and the next 50 at $15, regardless of their true cost.
The FIFO method helps mitigate those complications and maintain inventory 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 during inflation. As replacement costs rise, you’re paying tax on earnings that don’t fully reflect current expenses. This squeezes cash flow and limits your ability to reinvest.
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 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 the weighted average cost method might offer a more realistic view of your finances.
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.
FIFO Versus LIFO
The LIFO and FIFO methods are complete inverses—with LIFO, you sell the newest stock first.
Each method affects financial statements differently based on market conditions:
- LIFO during inflation: Selling newer (higher-cost) inventory first raises COGS and lowers taxable income.
- FIFO during stable or declining prices: Selling older (lower-cost) inventory first keeps COGS low and profits clearer.
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
Not all inventory platforms are created equal. Solutions like Fishbowl are configurable and user-friendly, helping you implement FIFO accounting while improving stock visibility. Key features include:
- Reporting capabilities
- Automation features
- Real-time insights through a no-nonsense interface
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.
Frequently asked questions
What is the FIFO method in inventory management?
FIFO (first in, first out) is both a stock rotation strategy where you sell the oldest inventory first and an accounting method where you assign the cost of your oldest inventory to items sold first. This approach maintains product freshness and typically results in lower COGS since older inventory usually costs less.
How do you calculate COGS using FIFO?
Multiply the quantity of inventory sold by the cost of your oldest units. For example, if you sell 50 units and your oldest batch cost $10 per unit, your COGS equals $500 ($10 × 50).
What is the difference between FIFO and LIFO?
FIFO sells the oldest inventory first and assigns older costs to COGS, while LIFO sells the newest inventory first and assigns newer costs to COGS. LIFO typically results in higher COGS and lower taxable income during inflation, but it’s not accepted under IFRS.
What equipment do you need to implement FIFO in a warehouse?
You need gravity flow or pallet rack systems that let teams feed goods into one side and retrieve them from the other, ensuring oldest stock moves out first. You also need inventory management software to track product entry and exit dates automatically.
Why does FIFO increase tax liability?
FIFO assigns lower costs to COGS, which increases your reported profits and taxable income. During inflation, you pay tax on earnings that don’t fully reflect current replacement costs, which squeezes cash flow.
When is FIFO not the best inventory method?
FIFO is less effective for industries like electronics, hardware, or luxury goods where products fluctuate in value based on demand, trends, or model upgrades. Alternative methods like LIFO or WAC might offer a more realistic view of finances in these cases.