The FIFO method is the first in, first out way of dealing with and assigning value to inventory. It is simple—the products or assets that were produced or acquired first are sold or used first. With FIFO, it is assumed that the cost of inventory that was purchased first will be recognized first. FIFO helps businesses to ensure accurate inventory records and the correct attribution of value for the cost of goods sold (COGS) in order to accurately pay their fair share of income taxes. Here’s what you need to know.

What Is First In, First Out (FIFO)?

First in, first out (FIFO) is an inventory method that assumes the first goods purchased are the first goods sold. This means that older inventory will get shipped out before newer inventory and the prices or values of each piece of inventory represents the most accurate estimation. FIFO serves as both an accurate and easy way of calculating ending inventory value as well as a proper way to manage your inventory to save money and benefit your customers.

Inventory is typically considered an asset, so your business will be responsible for calculating the cost of goods sold at the end of every month. With FIFO, when you calculate the ending inventory value, you’re accounting for the natural flow of inventory throughout your supply chain. This is especially important when inflation is increasing because the most recent inventory would likely cost more than the older inventory.

Advantages of FIFO

FIFO is a popular method to account for inventory because there are many advantages. From proper tracking of inventory to best serve customers to making sure your accounting software can manage the method you choose, FIFO has the edge over most other methods. Here are the most common advantages of the FIFO method:

  • Accurate cost analysis: FIFO provides the most accurate picture of what your inventory is costing the business at any given time. It aligns the current costs of the business with the actual flow of goods or inventory out of the business more accurately than any other method. This leads to better accounting and more real-time analysis on where the business stands if it has a heavy amount of inventory.
  • Software compatibility: Many accounting software options, including QuickBooks, only use the FIFO method to account for inventory. If you want to use a more complicated method, then you’ll likely need to find an expensive software or outsource your accounting.
  • Easy to use and apply: When using the FIFO method, you can easily apply the principles by managing inventory costs for the most recent purchases as each is recorded in order.
  • Higher profit calculation: The cost of goods tends to increase over time. Since you’re calculating the difference between what a product sold for currently with the cost to the business of the inventory in the past, you’re likely to see more profit than the products you’re buying in real time.

As you can see, the advantages with the FIFO method lead to it being the most popular inventory accounting method that is widely used across industries.

FIFO Example

To think about how FIFO works, let’s look at an example of how it would be calculated in a clothing store.

Let’s say that a new line comes out and XYZ Clothing buys 100 shirts from this new line to put into inventory in its new store. The beginning inventory of the 100 shirts cost $5 for each shirt. That is a total beginning inventory of $500.

Now, let’s assume that the store becomes more confident in the popularity of these shirts from the sales at other stores and decides, right before its grand opening, to purchase an additional 50 shirts. The price on those shirts has increased to $6 per shirt, creating another $300 of inventory for the additional 50 shirts. This brings the total of shirts to 150 and total inventory cost to $800.

Throughout the grand opening month of September, the store sells 80 of these shirts. All 80 of these shirts would have been from the first 100 lot that was purchased under the FIFO method. To calculate your ending inventory you would factor in 20 shirts at the $5 cost and 50 shirts at the $6 price. So the ending inventory would be 70 shirts with a value of $400 ($100 + $300).

FIFO vs. LIFO

While FIFO refers to first in, first out, LIFO stands for last in, first out. This method is FIFO flipped around, assuming that the last inventory purchased is the first to be sold. LIFO is a different valuation method that is only legally used by U.S.-based businesses. However, FIFO is the most common method used for inventory valuation.

Businesses using the LIFO method will record the most recent inventory costs first, which impacts taxes if the cost of goods in the current economic conditions are higher and sales are down. This means that LIFO could enable businesses to pay less income tax than they likely should be paying, which the FIFO method does a better job of calculating. It makes sense in some industries because of the nature and movement speed of their inventory (such as the auto industry), so businesses in the U.S. can use the LIFO method if they fill out Form 970.

FIFO Best Practices

In order to implement a strong FIFO system, it’s important to take into account both the accounting side as well as the inventory management side in your warehouse or store. There are best practices for both that make it important to follow so that you can properly manage your inventory to get a good cost analysis of your business as well as to best serve your customers. Here are a few best practices to implement:

  • Use accounting software: Any accounting software that has a component of inventory management will be familiar with the FIFO method, and many use it automatically. This will make your cost analysis much easier and more efficient.
  • Think about inventory flow: In order to make sure the first inventory is also the one that is sold, it’s important to think about how new inventory flows into your system. This is especially true if you’re managing perishable goods where the first in will also be the first to go bad.
  • Input inventory the day you receive it: It can be difficult to match inventory to purchase orders after the inventory has been loaded into your system and you’ve started to sell it. It’s best to log the cost into your accounting system as soon as you have the inventory so that it will automatically calculate in your software system when it is sold.

Bottom Line

FIFO is a widely used method to account for the cost of inventory in your accounting system. It can also refer to the method of inventory flow within your warehouse or retail store, and each is used hand in hand to manage your inventory. FIFO is the easiest inventory method to implement and use. In fact, it’s the only method used in many accounting software systems.

It’s recommended that you use one of these accounting software options to manage your inventory and make sure you’re correctly accounting for the cost of your inventory when it is sold. This will provide a more accurate analysis of how much money you’re really making with each product sold out of your inventory.

Frequently Asked Questions (FAQs)

Why is FIFO the best method?

FIFO is the best method to use for accounting for your inventory because it is easy to use and will help your profits look the best if you’re looking to impress investors or potential buyers. It’s also the most widely used method, making the calculations easy to perform with support from automated solutions such as accounting software.

What is the biggest con of using the FIFO method?

The biggest disadvantage to using FIFO is that you’ll likely pay more in taxes than through other methods. This is because the cost of goods typically increases over time so when you sell something in the present day and attribute your COGS to what you purchased it for months prior, your profit will be maximized.