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What is the FIFO Method?

What is the FIFO Method

FIFO, or “First In, First Out,” is an inventory valuation method where the first goods purchased or produced are assumed to be sold first. This means older inventory is accounted for before newer stock when calculating the cost of goods sold (COGS).

The FIFO method ensures that inventory management reflects the natural flow of goods, especially for products with short shelf life or time-sensitive qualities. Accounting uses the cost of the oldest inventory to determine the value of ending inventory, which often results in a higher valuation on balance sheets due to inflationary trends in production and raw material costs.

How the FIFO Inventory Valuation Method Works

FIFO is both an inventory management principle and an accounting method. Businesses using FIFO calculate their COGS by assuming they sell their oldest inventory first. This impacts how they value their remaining inventory at the end of an accounting period.

For example, if your oldest inventory was acquired at a lower cost, your recorded COGS will be lower, leading to higher profits. Conversely, more recent, higher-cost inventory remains in stock, contributing to a higher ending inventory valuation.

The FIFO Formula and Calculation Example

The FIFO method uses standard formulas for COGS and ending inventory.

COGS Formula:
COGS = Starting Inventory + Purchases − Ending Inventory

Ending Inventory Formula:
Ending Inventory = Starting Inventory + Purchases − COGS

Here’s an example:

Inventory Purchase 1: 20 units at $4 each = $80
Inventory Purchase 2: 80 units at $6 each = $480
Total Inventory: 100 units

If 50 units are sold during the accounting period:

First 20 units from Purchase 1 ($4 each): $80
Next 30 units from Purchase 2 ($6 each): $180

COGS = $80 + $180 = $260

The remaining inventory (50 units from Purchase 2) is valued at $300 for the balance sheet.

FIFO: Pros vs. Cons

Pros

  • Higher Valuation for Ending Inventory – FIFO tends to value ending inventory higher, which can improve a business’s balance sheet and minimize inventory write-offs.
  • Higher Net Income – With lower COGS, FIFO often reflects higher profits, making the business appear more lucrative to investors and stakeholders.
  • Reflects Actual Inventory Movement – FIFO aligns naturally with industries that prioritize selling older inventory first, such as food, cosmetics, and electronics, reducing waste and ensuring freshness.

Cons

  • Higher Taxes – Higher net income can result in increased tax liabilities, which may impact cash flow.
  • Accounting Discrepancies – In periods of rapid cost increases, such as sudden inflation or supply chain disruptions, FIFO can misrepresent actual profits, as older, cheaper inventory values are used in calculations.

Comparing FIFO to Other Inventory Valuation Methods

FIFO vs. LIFO

LIFO, or “Last In, First Out,” assumes the most recently acquired inventory is sold first. While it minimizes taxable income by using higher COGS during inflationary periods, LIFO often results in lower ending inventory valuations and is less aligned with actual inventory flow.

FIFO, accepted internationally under IFRS standards, provides more accurate profit representation and is generally preferred unless there’s a strategic tax advantage to LIFO.

FIFO vs. Average Cost

The average cost method calculates COGS and inventory valuation based on the weighted average cost of all inventory acquired during a specific period. While it smoothens out cost variations, it may not reflect real inventory flow or align with perishable goods’ requirements as effectively as FIFO does.

FIFO vs. Specific Inventory Tracing

Specific inventory tracking assigns a unique cost to every item, often used for rare or unique products like art or antiques. While precise, it’s impractical for businesses managing large volumes of standardized goods, where FIFO offers a more scalable approach.

Practical Applications of FIFO

  • E-commerce Businesses – FIFO aligns perfectly with brands selling perishable goods or items with an expiry date. It ensures timely inventory turnover and avoids obsolescence.
  • Seasonal Products – For brands selling seasonal inventory, FIFO prevents older, out-of-season stock from piling up.
  • Electronics and Fashion – Both industries rely on FIFO to manage product versions and trends, minimizing markdowns and ensuring profitability.

Financial Impact of FIFO

  • On Income Statements – FIFO typically results in lower COGS and higher gross profits, making the business appear more profitable during inflationary periods.
  • On Taxes – Higher profits often lead to higher taxable income, which can strain cash flow if not managed strategically.
  • On Balance Sheets – Ending inventory valuations under FIFO tend to be higher, which can make a business look healthier to investors and lenders.

When Should You Use FIFO?

FIFO is ideal for businesses that sell perishable or time-sensitive goods, operate in industries with consistent price increases, or need accurate and straightforward inventory records. For guidance on selecting the right method for your business, consult a CPA or financial expert.

Conclusion

FIFO remains one of the most widely used inventory valuation methods, offering simplicity, accuracy, and alignment with the natural flow of goods. By using FIFO, businesses can better manage inventory, maintain accurate financial records, and optimize profitability.

For E-commerce brands or businesses dealing with time-sensitive goods, adopting FIFO can help minimize waste, reduce inventory obsolescence, and build a strong financial foundation.

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