In this article, we will explore what the FIFO (First-In, First-Out) Inventory method is along with its advantages and disadvantages. We will also share our simple FIFO Inventory framework. Read on to learn more.
The FIFO (First-In, First-Out) inventory method is a way of valuing inventory and determining the cost of goods sold that assumes the oldest items in inventory are sold first. This means the cost of the earliest purchased or produced items is assigned to the cost of goods sold first with the cost of the newest items remaining in the ending inventory.
Example: Using the FIFO inventory method, if a company first bought 100 apples at $1 each and then 100 more at $2 each, upon selling 150 apples, the cost of goods sold would be calculated as $150 ($100 from the $1 batch and $50 from the $2 batch).
While the FIFO (First-In, First-Out) Inventory has advantages, it also has disadvantages. Let’s explore these below:
Here are the advantages of the FIFO Inventory method:
1. Matches Actual Flow for Certain Businesses: For businesses that deal with perishable goods or products with a limited shelf life, the FIFO method often mirrors the actual physical flow of inventory. It ensures that older stock is sold before newer stock which reduces the risk of spoilage or obsolescence.
2. Higher Reported Profits in Inflationary Periods: During times of rising prices, the FIFO method generally results in lower COGS as the oldest (and typically cheaper) inventory is recognized first. This leads to higher reported net income compared to other methods.
3. Simpler to Understand and Implement: FIFO is intuitive, especially for non-accounting professionals. It follows the logical sequence that the first items brought into inventory are the first ones sold.
4. Less Inventory Obsolescence: With FIFO, there's a lower risk of ending up with obsolete inventory on the balance sheet since the oldest items are sold off first. This can lead to a more accurate inventory valuation.
Here are the disadvantages of the FIFO Inventory method:
1. Higher Taxes in Inflationary Periods: Because FIFO can lead to higher reported profits during inflation, it might result in higher taxable income and a higher tax liability.
2. Doesn't Always Match Current Market Prices: In periods of rising prices, the ending inventory value (based on more recent costs) might be more aligned with current market values, but the COGS (based on older costs) does not reflect current market conditions.
3. Potential for Manipulation: If a company anticipates a sharp price increase for goods, it might stock up earlier to maintain a lower COGS. This leads to potential inventory overstock issues.
4. Not Always Representative of Cash Flow: During periods of fluctuating prices, FIFO's COGS might not represent the actual cash outflow for inventory as it's based on older and potentially lower costs.
Use our 10 step process to implement the FIFO Inventory method. Simply follow the process below:
Begin by pinpointing the items in your beginning inventory. These were in stock before any new additions during the accounting period.
Example: At the start of the month, a book store had 20 copies of "Mountain Echoes" priced at $12 each.
When new stock is acquired, record the quantity and the per-unit cost. Add these sequentially after the beginning inventory.
Example: On the 3rd, a grocery store acquired 50 bunches of bananas at $0.75 per bunch.
Note down each sale and specify the quantity of items sold. In FIFO, the oldest items (first acquired) are sold first.
Example: On the 10th, a gadget retailer sold 10 units of the older model, SmartPhone Z.
To compute the COGS for the sales, start with the cost of the oldest inventory and move forward. Multiply the number of units sold by the cost of each batch until accounting for all units sold.
Example: A bakery sold 40 croissants from a batch that cost $0.50 each, hence COGS is 40 x $0.50 = $20.
Subtract sold items from the total inventory to determine the ending inventory. The left-over units and their costs represent the ending inventory.
Example: After a sale, a boutique has 25 dresses from the summer collection remaining.
Multiply the quantities of the left-over items by their costs to find the total value of your ending inventory.
Example: Toyland has 15 toy trucks left with each priced at $20. The value is 15 x $20 = $300.
Update inventory records after every sale and at the end of the period to reflect changes in stock levels and values.
Example: By month-end, a pharmacy updated records showing 50 units of Vitamin C supplements left.
Occasionally, physically count inventory to ensure alignment with your records. Discrepancies can indicate issues like theft or recording mistakes.
Example: Hammer & Nail's count in February showed 5 fewer hammers than recorded, hinting at a possible issue.
Even with FIFO, monitor inventory aging, especially for perishable or soon-to-be obsolete items to prevent potential losses.
Example: Blooms & Petals is a florist shop that noticed some roses nearing their freshness limit and decided to offer a discount.
Review the entire FIFO process periodically for efficiency. Adjust purchasing habits, sales strategies, or even the method if necessary.
Example: Java Junction observed that a particular coffee blend wasn't selling quickly so they reduced its order frequency.
SwiftSoles is a retailer that wants to implement the FIFO method. Here’s how they implemented our simple 10 step process:
At the onset of April, SwiftSoles had an existing inventory of 200 pairs of "Spring Breeze" sandals priced at $30 each. This inventory will be the base upon which they add their new purchases.
By April 7th, to get ready for summer, they bought 300 pairs of "Summer Sun" flip-flops at $25 per pair. They extended their inventory to include this new addition alongside the "Spring Breeze" sandals.
Throughout April, SwiftSoles noted that they sold 150 pairs of "Spring Breeze" sandals. They adhere to the FIFO method which means selling the older stock first.
The cost associated with the sold sandals is computed as 150 pairs multiplied by their cost price, $30, totaling $4,500 in COGS for April's sales.
After April's sales, SwiftSoles tallied their inventory to find they had 50 pairs of "Spring Breeze" sandals and 300 pairs of "Summer Sun" flip-flops remaining.
The total value for the leftover inventory is calculated as (50 sandals x $30) + (300 flip-flops x $25) which sums up to $1,500 + $7,500 = $9,000.
SwiftSoles diligently updated their records at the end of April to reflect the remaining 350 pairs of footwear. This ensures their system and physical count align.
Mid-May, SwiftSoles conducted a routine check by physically counting the stock. They identified that everything matched their records. This confirms the effectiveness of their tracking.
By the end of May, SwiftSoles noticed they still had 40 pairs of "Spring Breeze" sandals. To ensure they don't keep old stock too long, they decided to hold a mid-season sale to encourage their purchase.
At the end of the quarter, SwiftSoles reviewed their sales trends and realized the "Summer Sun" flip-flops were selling faster than expected. As a result, they decided to increase the order quantity for the next batch to better meet demand.
We hope that you now have a better understanding of what the FIFO Inventory method is and how to calculate it to ensure the timely sale of your inventory.
If you enjoyed this article, you might also like our article on inventory modeling or our article on is inventory a liquid asset.
