Organising your inventory and calculating the cost of your goods is a fundamental part of running an efficient business. Get this right and you’ll make life a lot easier at the end of the financial year – get it wrong and your risk of incorrectly filing your taxes skyrockets.
First in first out (FIFO) is one of the most common inventory management and accounting methods. So, what does FIFO mean, when would you use it, and is it right for your business?
What is FIFO?
First-in, first-out (FIFO) is an inventory accounting method for valuing stocked items. FIFO assumes the most recently purchased goods are the last to be resold and the least recently purchased goods are the first to be sold.
In inventory management, FIFO helps to reduce the risk of carrying expired or otherwise unsellable stock. In accounting, it can be used to calculate your cost of goods sold (COGS) and tax obligations.
FIFO in inventory management
For companies in sectors such as the food industry, where goods are at risk of expiring or being made obsolete, FIFO is a useful strategy for managing inventory in a manner that reduces that risk. In inventory management, the FIFO approach requires that you sell older stock or use older raw materials before selling or using newer goods and materials. This helps reduce the likelihood that you’ll be stuck with items that have spoiled or that you can’t sell.
FIFO in accounting
FIFO is also an important costing and inventory valuation method used by accountants to determine tax obligations and understand cost of goods sold. In the FIFO method, your cost flow assumptions align with how the business actually operated in a given period.
This is one of the most common cost accounting methods used in manufacturing, and it’s particularly common among businesses whose raw material prices tend to fluctuate over time. FIFO takes into account inflation; if prices went up during your financial year, FIFO assumes you sold the cheaper ones first, which can lead to lower expenses and higher reported profit.
How to calculate FIFO
To calculate FIFO, select a time period you would like to calculate. Determine the cost of the oldest inventory from that period and multiply that cost by the amount of inventory sold during the period.
In the case of price fluctuations, you’ll need to calculate FIFO in batches. For example, let’s say you purchased 50 items at $100 per unit and then the price went up to $110 for the next 50 units. Using the FIFO method, you would calculate the cost of goods sold for the first 50 using the $100 cost value and use the $100 cost value for the second batch of 50 units.
To determine total COGS for the period, the formula for using the FIFO method would look like this:
(Number of Units in Batch 1 × Unit Price of Batch 1) + (Number of Units in Batch 2 × Unit Price of Batch 2) = Cost of Goods Sold
- Note: Notice how Batch 1 and Batch 2 are calculated separately, and Batch 2 is calculated at its own purchase price, not the purchase price of Batch 1. When using FIFO, we don’t assume that everything purchased costs the same. Individual purchases are calculated based on their purchase price.
From here you can calculate your ending inventory value, which will be based on the purchase cost of the later units:
Remaining Units × Cost of Remaining Units = Ending Inventory
To better demonstrate how FIFO works, let’s use an example.
Imagine you own a tuna cannery. At the start of the financial year, you purchase enough fish for 1,000 cans. Each can cost $1 per unit. Later in the year, you stock up again. However, the price has gone up to $2 a unit.
Let’s say you have 2,000 units to sell. You sell 1,500. Using FIFO, you assume the first 1,000 sold cost $1 per unit, and the remaining 500 cost $2 per unit. That leaves you with 500 units in our ending inventory, valued at $2 per unit.
Here’s how our FIFO example looks when we break it down:
Price per unit
As we mentioned, 1,500 units were sold during the period.
The FIFO calculation for example then looks like this:
COGS = (1,000 × $1) + (500 × $2) = $2,000
The ending inventory value calculation looks like this:
Ending inventory value = (500 × $2) = $1,000
Advantages of FIFO
Compared to other inventory valuation methods, FIFO offers some significant advantages:
- Higher net profit: FIFO typically produces a higher ending inventory value with lower expenses in a given period. The result is a higher recorded net profit. This can make a business’s financials more appealing to investors.
- Accounting reflects reality: If you’re organising your warehouse from oldest to newest and then accounting the same way at EOFY, you’ll likely find your finances easier to understand. This is because your records will accurately reflect your true profits.
- Accurate current inventory value: Accounting using FIFO means that your recorded ending inventory value will be closer to its actual value. Alternative cost accounting methods like LIFO may undersell what you actually have in stock.
- Useful during inflation: If inflation is a problem for your industry, FIFO makes it easier to adjust to any changes. Your expenses will be taken into account using cheaper goods first, with your ending inventory value reflecting the inflated prices.
- Compliant with International Financial Reporting Standards (IFRS): Unlike the LIFO method, FIFO is legal to use in most countries as it is accepted under the IFRS.
Disadvantages of FIFO
Despite its popularity, the FIFO method does have a few downsides:
- Not ideal for price spikes: Prices don’t always rise gradually. Assuming they spike during a financial year, you’re likely going to see a large discrepancy between recorded profit and actual profit.
- Deflation can impact accuracy: Using FIFO in a deflationary environment could lead to higher COGS without a higher ending inventory value to offset it. This means your records may not accurately represent the actual value of your inventory.
- It can overstate profits: Whether there’s a price spike or not, FIFO can sometimes overstate recorded profit to an unhealthy degree. Your actual inventory value will not match what is being written down, which could lead to cash flow challenges later on.
- You need good records: You’ll need good inventory management software to best track costs and implement a FIFO system. This is because you’re going to have to track purchased units to a granular level, which can be difficult when relying on manual processes.
FIFO vs LIFO
Often compared, FIFO and LIFO (last in, first out) are inventory accounting methods that work in opposite ways. Where FIFO assumes that goods coming through the business first are sold first, LIFO assumes that newer goods are sold before older goods.
Currently, LIFO is not legal to use everywhere in the world, as it is forbidden under the International Financial Reporting Standards. However, it is recognised by the US Generally Accepted Accounting Principles (GAAP).
As LIFO is the opposite of FIFO, it typically results in higher recorded COGS and lower recorded ending inventory value, making recorded profits seem smaller. This can be of tax benefit to some organisations, offering tax relief and providing cash flow benefits as a result. However, it may not look as good to investors.
- Learn more: FIFO vs LIFO: Advantages & Disadvantages
Other cost accounting methods
FIFO and LIFO aren’t your only options when it comes to inventory accounting.
Other cost accounting methods include:
- Weighted average cost (WAC): WAC averages out the purchase cost of your entire inventory instead of working it out in batches. This makes it easier to calculate (though this is often not ideal in a highly variable market).
- Specific identification method: This approach tracks each item bought by the company and calculates COGS and inventory values on the product level, not the batch level.
- HIFO and LOFO: These methods assume the highest-cost items are sold first or the lowest-cost items are sold first respectively, regardless of in which order they were purchased.
- FEFO: FEFO assumes that ‘first expired’ items will be the first out the door, making it useful in a food manufacturing or pharmaceutical context.
Do you have a choice when it comes to using FIFO?
If you’re comparing FIFO with LIFO, you may not have a choice in which inventory accounting method you use. Any business based in a country following the IFRS (such as Australia, New Zealand, the UK, Canada, Russia, and India) will not have access to LIFO as an option.
However, there are other options available to you. Your products, country, tax expectations, financial reporting objectives, and industry norms will help you define what inventory accounting method is right for your business.
We recommend consulting a financial expert before making any decisions around inventory valuation.
How to make calculating FIFO easier
Unless you’re using a blended-average accounting method like weighted average cost, you’re probably going to need a way to track, sort, and calculate all your individual products or batches.
Spreadsheets and accounting software are limited in functionality and result in wasted administrative time when tracking and managing your inventory costs.
Modern inventory management software like Unleashed helps you track inventory in real time, via the cloud. This gives you access to data on your business financials anywhere in the world, even on mobile, so you can feel confident that what you’re seeing is accurate and up-to-date.