Inventory management and accounting methods may be the last thing on a retailer’s mind as we head into peak season. But given the vast number of stock reorders and replenishments that will occur as brands brace for a surge in demand, now seems as good a time as any to consider how to value your inventory best.
FIFO (First In, First Out) is one of the most common inventory valuation methods. In this article, we’ll explore what FIFO is, how it works, and how it compares to other methods like LIFO.
What is First In, First Out (FIFO)?
First In, First Out (FIFO) is an inventory management and valuation method, which assumes you always sell goods in the order you purchase them. In other words, you account for the cost of older inventory before newer stock.
Why does this matter?
The prices your suppliers charge seldom stay the same. Whether it’s inflationary price increases or problems with the supply chain, there’s a good chance you’ll pay more for the same products when you come to reorder them.
That can make valuing your inventory tricky unless you use a method like FIFO.
How does FIFO work?
The FIFO method is relatively straightforward. As the name suggests, it assumes you sell all of your oldest inventory before new stock when creating your accounts. It doesn’t matter if you actually sell new stock before you use up all of your existing stock — it’s for accounting purposes only.
Imagine your company buys 100 products in January for £5 each and then reorders another 100 products in March for £6 each. You sell 150 units by June. In your accounts, you’ll calculate the cost of the first 100 units at £5 and the next 50 at £6 per unit instead of calculating the cost of all of the goods at £6 per unit.
If you calculated the cost of all of the goods at £6, you’d be using the Last In, First Out (LIFO) method.
How to calculate FIFO
FIFO isn’t a calculation itself; it is a method for calculating accounting terms like the cost of goods sold (COGS) and the value of your remaining inventory.
The formula for COGS under the FIFO method is:
COGS = Starting Inventory + Purchases − Ending Inventory
To calculate ending inventory using the FIFO method:
Ending Inventory = Starting Inventory + Purchases − COGS
An example of FIFO in action
Let’s look at a real-world example of how FIFO works.
Your clothing store purchases 200 jackets in January for £10 each and another 100 jackets in May for £15 each. By the end of the year, you sell 250 jackets.
Here’s how to calculate the cost of goods sold and the value of remaining inventory using the FIFO method:
COGS calculation:
The first 200 jackets sold are from the January batch, costing £10 each, totalling £2,000. The following 50 jackets sold are from the May batch, costing 15 each, totalling £750.
Total COGS = £2000 (the total cost of the January batch) + £1500 (the total cost of the May batch) - £750 (the cost of the ending inventory) = £2750.
Ending inventory calculation:
After selling 250 jackets, the store has 50 jackets left from the May batch. These jackets are valued at £15 each, so the ending inventory value is £750.
For reference, your COGS would be £3000 and ending inventory £500 using the LIFO method. By using FIFO, therefore, you record a lower COGS and higher ending inventory, which can positively impact profits and inventory valuation.
What are the benefits and challenges of FIFO?
There are plenty of reasons retailers use FIFO. The main benefits are:
- An accurate reflection of inventory: FIFO offers an accurate reflection of inventory costs, especially in times of inflation. By assuming the oldest inventory is sold first, businesses can more closely match their financial statements with real-world inventory movement.
- Higher ending inventory valuations: FIFO accounts for newer, more expensive stock as part of the ending inventory, rather than the cheaper initial stock.
- It’s easy to implement: FIFO aligns with the natural flow of goods, especially for businesses dealing with perishable items or products with expiration dates. It’s easier to implement in practice compared to methods like LIFO, which can be more complex.
However, there are some challenges with FIFO that retailers need to consider.
- Potentially higher tax bills: FIFO often results in higher profits due to lower COGS, so businesses can face higher tax bills.
- It doesn’t work if prices surge: If you experience rapid and significant price increases, your COGS calculation under the FIFO method may not accurately reflect current market conditions.
FIFO vs. LIFO
LIFO is the opposite of FIFO and assumes you sell your most recently acquired inventory first. This method is popular in industries where the cost of goods rises quickly and businesses want to minimise their tax liabilities as a result.
Here are the key differences between FIFO and LIFO:
- Inventory flow: FiFO assumes old inventory is sold first, whereas LIFO assumes new inventory is sold first.
- Cost of Goods Sold (COGS): Your COGS under FIFO usually ends up lower during periods of inflation because the cheaper inventory is recorded first. The opposite is true under LIFO where the higher costs are taken into account.
- Ending inventory: Using FIFO, ending inventory reflects the cost of your most recent purchases, which means inventory valuations will be higher (assuming prices are rising).
- Tax implications: LIFO can provide a tax advantage because it results in higher COGS and lower taxable income.
Choosing between FIFO and LIFO depends on the nature of your business, the products you sell, and the economic conditions you operate in.
Final thoughts
Understanding how FIFO works, how it compares to LIFO, and how to calculate it can help businesses make better decisions about their inventory management practices.
Whether you use FIFO or LIFO, though, you need to get your inventory to customers on time by working with an expert delivery partner. That’s why global retailers trust Pro Carrier. Our dedicated international shipping solution makes it easy for online retailers to deliver everywhere they sell. Our custom-built platform integrates with every eCommerce solution, meaning you can monitor, edit and track shipments from a single screen.
Speak to one of our experts today for more information.