Below, we’ll explore the FIFO method for calculating inventory, when it’s best used, and some benefits and drawbacks companies should consider before implementing this method.
FIFO is an abbreviation for the “First In, First Out” method of valuing inventory. This compares to the other two common methods: average cost inventory or “Last In, First Out” (LIFO).
Using FIFO, companies will assume the oldest items in their inventory are sold first. Thus, the value of their current inventory is based on the cost of the most recent purchases. This method helps to prevent obsolescence and assumes only the newest-received items remain in inventory.
It’s important to point out that companies don’t necessarily need to keep track of the age of each individual item in their inventory and ensure they’re selling out the oldest items first. The FIFO method is based on an assumption that gives a company structure for monitoring cash flows and valuing their inventory.
The value of inventory that’s calculated using the FIFO method is then used in the cost of goods sold (COGS) formula. The COGS is reported on the income statement, which gets subtracted from total revenues to determine your gross profit for the period.
Since there are three common options for valuing inventory, you might wonder when the FIFO method is most appropriate, or why companies will choose this option over the others.
In general, FIFO is a good option to use during inflationary periods, as it can result in higher profits and more attractive financial performance. For example, if the oldest items in your inventory were purchased at a time when costs were lower, using these values to calculate the current COGS and gross profits will create better-looking financial statements.
FIFO also reflects the regular flow of goods for specific industries, such as food, pharmaceuticals, and any other company that sell perishable items. These companies tend to sell the oldest items first to prevent spoilage and waste. So, the assumptions of the FIFO method already align with their regular business practices and more accurately reflect the flow of goods.
Regardless of which method you choose to value inventory, companies must remain consistent with a method once they’ve chosen it to stay compliant with generally accepted accounting principles (GAAP) and produce accurate financial reporting.
To better understand the FIFO inventory method and how it compares to LIFO or average cost, let’s now take a look at an example of how this method can be used in the real world.
An online retailer specializes in selling on-trend clothing and accessories. They experience high inventory turnover due to the nature of fashion trends, so they decide to use the FIFO inventory method.
To get ready for the summer season, the store receives a new shipment of swimsuits, though they already have some in stock from previous orders. To maintain the quality of their inventory and prevent obsolescence, the company will focus on selling the older stock first before they sell items from the latest deliveries.
Here is a breakdown of the current items in stock before the most recent shipments:
Then, they receive a new shipment, which looks like:
During the next month, the online retailer sells 100 swimsuits. Under the FIFO method, this means they will sell the older stock first. So, after accounting for the current period sales, there are still 25 swimsuits from the older stock remaining. This is valued at:
25 * $15 = $375
Then, we’ll need to add this to the value of the most recent shipment, all of which remains in inventory at a value of $2,000, as we previously calculated.
Combining these two values, we determine that the current value of inventory under the FIFO method is:
$375 + $2,000 = $2,375
Thus, $2,375 is the company’s ending inventory value for the period. This is the value that is used in the COGS formula.
After seeing the FIFO method in action, it’s easier to understand how it’s applied and why companies might choose it over the other available methods.
However, there are some important advantages and disadvantages of the method to consider, which we’ll outline below.
FIFO is one of the most common methods for calculating inventory. It’s a popular option because its assumptions closely mimic how many companies already manage inventory, with older items sold ahead of newer units.
Companies have a choice over which method they select. However, they need to be consistent once they make their decision. So, it’s important to properly weigh the pros and cons to ensure FIFO is the best option for your financial situation.
If you want expert guidance on which method to select and how to implement it, contact us at Bob’s Bookkeepers to speak with one of our experienced advisors today.
