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What is the FIFO Method and How Can it Be Used?

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When Susan first opened her pet supply store, she quickly discovered her vegan pumpkin dog treats were a huge hit and bringing in favorable revenue. But when it was time to replenish inventory, her supplier had increased prices.

Though some products are more vulnerable to fluctuating price changes, dealing with inflation when restocking inventory is inevitable. 

But no matter what you sell, keeping track of inventory value over time is essential. So how should a brand keep track of fluctuating inventory value over time?

To ensure accurate inventory records, one of the most common methods is FIFO (first-in, first-out), which assumes the oldest inventory was sold first and the value is calculated accordingly.

Read on for a deeper dive on how FIFO works, how to calculate it, some examples, and additional information on how to choose the right inventory valuation for your business.

FIFO stands for first in, first out, an easy-to-understand inventory valuation method that assumes that the first goods purchased or produced are sold first. In theory, this means the oldest inventory gets shipped out to customers before newer inventory. 

To calculate the value of ending inventory, the cost of goods sold (COGS) of the oldest inventory is used to determine the value of ending inventory, despite any recent changes in costs.

How the FIFO inventory valuation method works

Since ecommerce inventory is considered an asset, you are responsible for calculating COGS at the end of the accounting period or fiscal year. Ending inventory value impacts your balance sheets and inventory write-offs.

Due to inflation, the more recent inventory typically costs more than older inventory. With the FIFO method, since the lower value of goods are sold first, the ending inventory tends to be worth a greater value.

Additionally, any inventory left over at the end of the financial year does not affect cost of goods sold (COGS).

It’s important to note that FIFO is designed for inventory accounting purposes and provides a simple formula to calculate the value of ending inventory. But in many cases, what’s received first isn’t always necessarily sold and fulfilled first.

However, if you sell items that have a short shelf-life, are perishable, or tend to go obsolete quickly, the FIFO method provides a dual advantage of proper inventory management and an easy method for calculating ending inventory value.

Calculating inventory value that matches the natural flow of inventory throughout your supply chain, you’re able to track and regulate quality and offset the risk of high holding costs for storing inventory that is obsolete or no longer sellable (also known as dead stock).

Though it’s the easiest and most common valuation method, the downside of using the FIFO method is it can cause major discrepancies when COGS increases significantly.

If product costs triple but accountants use values from months or years back, profits will take a hit. It also does not offer any tax advantages unless prices are falling.

Examples of calculating inventory using FIFO

According to the FIFO cost flow assumption, you use the cost of the beginning inventory and multiply the COGS by the amount of inventory sold. 

Let’s revisit Susan’s pet supply store. Originally, Susan bought 80 boxes of vegan pumpkin dog treats at $3 each. Later on, she bought 150 more boxes at a cost of $4 each, since the supplier’s price went up.

  • Susan now has 230 boxes of dog treats in stock.
  • Of these, 100 boxes of dog treats have been sold.

Using the FIFO method of inventory valuation, Susan assumes that she sold all 80 of the original boxes before dipping into the newer stock. Thus, in her balance sheet, the total cost of goods she sold above (100 boxes) would be:

COGS = (The Number of Original Units x Their Value) + (Remaining Units From the Second Purchase x Their Value)

COGS = (80 x $3) + (20 x $4) = $320

Notice that the cost of the oldest inventory items are used first in the COGS calculations (the initial purchase of 80 boxes at $3/each) and the remaining 20 boxes use the second purchase cost of $4/each. The value of the remaining or ending inventory (130 boxes) is then calculated:

Ending Inventory Value = Remaining Units x Their Value

Ending Inventory Value = 130 x $4 =  $520

Consider another example of a manufacturer producing the dog treats. The company produced 2 batches of the pumpkin treats with the following specifications:

Batch Unit count Cost per unit Total cost
Batch 1 10 $30 $300
Batch 2 50 $40 $2,000

Under FIFO, the manufacturer would assume that if they were to sell 20 units of the 60 total units in stock, 100% of Batch 1 (10 units from Batch 2 (the remaining 10 units at $40/each) were sold. The COGS would be calculated accordingly:

COGS = (The Number of Original Units x Their Value) + (Remaining Units From the Second Purchase x Their Value) 

COGS = (10 x $30) + (10 x $40)  = $700  

And, the ending inventory value is calculated by adding the value of the 40 remaining units of Batch 2.

Ending Inventory Value = Remaining Units x Their Value

Ending Inventory Value = (40 x $40) = $1,600

While there is no one “right” inventory valuation method, every method has its own advantages and disadvantages. Here are some of the benefits of using the FIFO method, as well as some of the drawbacks. 

Pro: Higher valuation for ending inventory

As mentioned above, inflation usually raises the cost of inventory as time goes on. This means that goods purchased at an earlier time are usually cheaper than those same goods purchased later. 

Because FIFO assumes that the lower-valued goods are sold first, your ending inventory is primarily made up of the higher-valued goods. As a result, your ending inventory value is higher. 

A higher inventory valuation can improve a brand’s balance sheets and minimize its inventory write-offs, so using FIFO can really benefit a business financially.  

Pro: Higher net income

The FIFO valuation method generally enables brands to log higher profits – and subsequently higher net income – because it uses a lower COGS. 

Suppose a coffee mug brand buys 100 mugs from their supplier for $5 apiece. A few weeks later, they buy a second batch of 100 mugs, this time for $8 apiece. They sell every mug for $15, and sell 100 units. 

Under FIFO, the brand assumes the 100 mugs sold come from the original batch. On each sale, the net profit is $10 ($15 sale price – $5 COGS). Because the brand is using the COGS of $5, rather than $8, they are able to represent higher profits on their balance sheet.

Pro: Often reflects actual inventory movement

For many businesses, FIFO is a convenient inventory valuation method because it reflects the order in which inventory units are actually sold. This is especially true for businesses that sell perishable goods or goods with short shelf lives, as these brands usually try to sell older inventory first to avoid inventory obsoletion and deadstock. 

While using FIFO doesn’t mean brands must sell the oldest goods first in reality, it is extremely intuitive for brands that do and helps simplify inventory accounting. 

Con: Discrepancies if COGS spikes

FIFO works best when COGS increases slightly and gradually over time. If suppliers or manufacturers suddenly raise the price of raw materials or goods, a business may find significant discrepancies between their recorded vs. actual costs and profits. 

For instance, say a candle company buys a batch of 1,000 candles from their supplier at $2 apiece.Several months later, the company buys another batch of 1,000 candles – but this time, the supplier charges $10 for each candle. 

This is a significant increase in COGS for the brand. When they use FIFO to calculate ending inventory value, the brand will use the lower COGS – but because that number is outdated and COGS has spiked since then, the company’s recorded profits on the balance sheet will not necessarily match their actual profits (with actual profits being much lower than represented). 

Con: Higher taxes

Because net income is usually higher for brands using FIFO, those brands’ income taxes are usually higher as well. For certain businesses, this can cause cash flow issues and eat further into their bottom lines.

LIFO stands for last in, first out, which assumes goods purchased or produced last are sold first (and the inventory that was most recently purchased will be sent to customers before the oldest inventory). It is an alternative valuation method and is only legally used by US-based businesses.

FIFO, on the other hand, is the most common inventory valuation method in most countries, accepted by IFRS International Financial Reporting Standards Foundation (IRFS) regulations.

Businesses that use the FIFO method will record the original COGS in their income statement. With LIFO, it’s the most recent inventory costs that are recorded first.

If COGS are higher and profits are lower, businesses will pay less in taxes when using LIFO. Of course, the IRA isn’t in favor of the LIFO method as it results in lower income tax.

However, it does make more sense for some businesses (a great example is the auto dealership industry). For this reason, the IRS does allow the use of the LIFO method as long as you file an application called Form 970.  

Compared to LIFO, FIFO is considered to be the more transparent and accurate method. It also tends to result in higher gross profit than LIFO.

FIFO vs. Average Cost Inventory

The average cost inventory valuation method uses an average cost for every inventory item when calculating COGS and ending inventory value. 

A business would calculate the average cost of every inventory unit (within a certain accounting period) using this formula:

Average Cost of Inventory = (Total cost of all goods purchased) / (total number of inventory units purchased)

The brand then uses that average in their COGS and ending inventory value calculations. 

In contrast, FIFO does not use averaging. Rather, every unit of inventory is assigned a value that corresponds to the price at which it was purchased from the supplier or manufacturer at a specific point in time. 

While this distinction may seem like a trivial detail, it does impact a business’s COGS, ending inventory value, and how much profit a business books. 

For example, say that a trampoline company purchases 100 trampolines from a supplier for $40 apiece, and later purchases a second batch of 150 trampolines for $50 apiece. The company sells every trampoline for $80, and sells 200 of them. 

Here is a breakdown of how a business would calculate COGS, ending inventory value, and profit using the average inventory method vs. FIFO:

Average Cost Inventory FIFO
Average Cost of Inventory: = ([100 x $40] + [150 x $50]) / (100 + 150)= ($4,000 + $7,500) / 250= $11,500 / 250= $46 N/A
COGS = (100 x $46) + (100 x $46) = $9,200 = (100 x $40) + (100 x $50)= $9,000
Ending Inventory Value = 50 x $46 = $2,300 = 50 x $50= $2,500
Profit  Total sales price – COGS= ($80 x 200) – $9,200= $16,000 – $9,200= $6,800 Total sales price – COGS= ($80 x 200) – $9,000= $16,000 – $9,000= $7,000

As you can see, the FIFO method of inventory valuation results in slightly lower COGS, higher ending inventory value, and higher profits. This makes the FIFO method ideal for brands looking to represent growth in their financials. The average cost method, on the other hand, is best for brands that don’t see the cost of materials or goods increasing over time, as it is more straightforward to calculate. 

FIFO vs. Specific Inventory Tracing

Specific inventory tracing is an inventory valuation method that tracks the value of every individual piece of inventory. This method is usually used by businesses that sell a very small collection of highly unique products, such as art pieces. 

Using specific inventory tracing, a business will note and record the value of every item in their inventory. Inventory value is then calculated by adding together the unique prices of every inventory unit. 

For example, say a rare antiques dealer purchases a mirror, a chair, a desk, and a vase for $50, $4,000, $375, and $800 respectively. The total inventory value would be $5,225. If the dealer sold the desk and the vase, the COGS would be $1,175 ($375 + $800), and the ending inventory value would be  $4,050 ($4,000 + $50). 

FIFO is different from specific inventory tracing in that it assumes that one piece of inventory is more or less identical to another – and as long as they were purchased at the same time and for the same price, they are also equally valuable.

Of course, you should consult with an accountant but the FIFO method is often recommended for inventory valuation purposes.

If you sell a product that requires fulfilling older inventory first for quality purposes (especially if you sell perishables and other types of time-sensitive goods), the FIFO method will follow the natural flow of inventory, providing accurate numbers. 

For retailers dealing with food items, cosmetics, or electronics, for example, the FIFO method helps to avoid having to write off or write down inventory from the oldest received, in case demand is slower-moving than expected.

Additionally, it ensures that you are more likely to use the actual price you paid for the goods in your income statements, making the calculations more accurate and simple, and record-keeping much easier. 

FIFO is also the option you want to choose if you wish to avoid having your books placed under scrutiny by the IRS (tax authorities), or if you are running a business outside of the US.

ShipBob’s tech-enabled retail fulfillment solution is designed for fast-growing B2B ecommerce and direct-to-consumer brands

For inventory tracking purposes and accurate fulfillment, ShipBob uses a lot tracking system that includes a lot feature, allowing you to separate items based on their lot numbers.

When you send us a lot item, it will not be sold with other non-lot items, or other lots of the same SKU. 

Following the FIFO logic, ShipBob is able to identify shelves that contain items with an expiration date first and always ship the nearest expiring lot date first.

If you have items stored in different bins — one with no lot date and one with a lot date — we will always ship the one updated with a lot date first.

“We also have easy ways to manage subscription orders as well as expiration dates and lot numbers, so inventory goes in First In, First Out (FIFO).”

Leonie Lynch, Founder & CEO of Juspy

Our premium fulfillment software’s built-in inventory management tools also help you to:

With this level of visibility, you can optimize inventory levels to keep carrying costs at a minimum while avoiding stockouts.

inventory summary and turnover from ShipBob's analytics tool

We also offer Develop API to enable a custom-built inventory management solution that ties into your accounting platform, to keep financial statements up-to-date, even when order volumes are skyrocketing.

“We utilize ShipBob’s Inventory API, which allows us to programmatically retrieve real-time data on how many units of each product are currently stored at ShipBob’s warehouses. We currently use this API to generate custom reports to tie this inventory data into our accounting platforms.”

Waveform Lighting Team

Interested to see our fulfillment solution in action? Check out a 3D behind the scenes look at how ShipBob operates:

Whether you’re a business owner or an ecommerce operations manager, ShipBob can help you expand your distribution logistics network and manage the flow of goods throughout your entire ecommerce supply chain without being involved in the day-to-day logistics operations.

To grow your brand with ShipBob, get the process started by requesting custom pricing.

Unlock Turbo Warehouse Management with ShipBob’s WMS

For brands looking to store inventory and fulfill orders within their own warehouses, ShipBob’s warehouse management system (WMS) can provide better visibility and organization.

Ecommerce merchants can now leverage ShipBob’s WMS (the same one that powers ShipBob’s global fulfillment network) to streamline in-house inventory management and fulfillment.

With real-time, location-specific inventory visibility, intelligent cycle counts, and built-in checks and balances, your team can improve inventory accuracy without sacrificing operational efficiency.

For brands looking to scale internationally, ShipBob even offers a hybrid solution where merchants can employ ShipBob’s WMS technology in their own warehouses while simultaneously leveraging ShipBob’s fulfillment services in any of ShipBob’s fulfillment centers across the US, Canada, Europe, and Australia to improve cross-border shipping, reduce costs, and speed up deliveries.

Here are answers to the most common questions about the FIFO inventory method. 

 

Post Disclaimer

The information provided in our posts or blogs are for educational and informative purposes only. We do not guarantee the accuracy, completeness or suitability of the information. We do not provide financial or investment advice. Readers should always seek professional advice before making any financial or investment decisions based on the information provided in our content. We will not be held responsible for any losses, damages or consequences that may arise from relying on the information provided in our content.

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