Proper inventory management is necessary for those businesses which buy, produce, keep and then sell physical goods. The method of allocation of cost of the inventory can have an impact on the cost of goods sold (COGS), profit shown in accounting, ending inventory and financial statements. First In, First Out, or FIFO, is one of the most popular methods of allocating cost of the inventory. According to this method, the cost of the oldest inventory is allocated first for the cost of the goods sold.
This blog will help us to learn FIFO inventory management. In order to do so, we will learn about the working of First In, First Out inventory systems, the impact of FIFO on COGS and financial statements and how FIFO compares to LIFO.
What Is FIFO Inventory Management and How Does It Work?
FIFO is an acronym for First-In, First-Out. The presumption here is that the cost associated with the oldest inventory is used to account for the cost of the earliest goods sold, whereas the cost of recent purchases is reflected in the ending inventory. This cost flow assumption tends to follow the physical flow of the goods.
Understanding the FIFO Method
If the retailer buys 100 units for $10 each and then buys 100 more units for $12 each, then under FIFO, the initial 100 units would be priced at $10 each while the additional 20 units are priced at $12 each.
The resulting COGS would therefore be:
100 × $10 + 20 × $12 = $1,240
At that point, the value of the 80 units of inventory left is $12 per unit, for a total value of $960. The above example provides an understanding of how FIFO links inventory costs with sales costs.
FIFO and Cost of Goods Sold
The cost of goods sold is the cost incurred for the goods sold during a particular accounting period. Using the FIFO method of valuation, the cost of the oldest inventory available is usually allocated to the cost of goods sold.
This is especially true when the cost of purchases varies. In an increasing cost environment, the cost of goods sold using FIFO would be less than that under LIFO because the older inventory was bought at a cheaper cost. Assuming prices are stable, this may lead to higher profits than under LIFO.
FIFO and Ending Inventory
FIFO results in the newest cost of goods being kept in ending inventory. With rising prices, FIFO can lead to the reported inventory being closer to current costs than other methods that result in older costs being included in ending inventory.
For companies that hold large amounts of inventory, the ending balance can have a significant impact on their financial statements and ratios. It is thus important for companies to maintain accurate inventory records irrespective of the costing method used.
FIFO vs. LIFO: What Is the Difference?
The methods FIFO and LIFO differ in terms of which costs they associate with sales in respect to inventory. This difference may have an impact on COGS, ending inventory, gross profit, and taxable income.
FIFO vs. LIFO During Rising Prices
As far as rising inventory costs are concerned, FIFO typically allocates older, lower costs first to COGS. That would mean having lower COGS and greater gross profit, all things being equal.
In LIFO accounting, it is the newer cost that is allocated first to COGS. With rising inventory costs, this could result in a greater COGS and lower profits. The tax implication will depend on the prevailing tax laws and business situation, so it is unwise to select an inventory system simply based on the expectation of lowering taxes.
FIFO vs. LIFO Under U.S. GAAP and IFRS
It is important to note that the accounting system will determine the approach to be used in valuing inventories. As far as U.S. GAAP is concerned, FIFO and LIFO are allowed cost flow assumptions provided the inventory satisfies all the requirements of accounting standards. LIFO is not allowed under IFRS. IAS 2 allows FIFO and weighted average cost approach for interchangeable inventories.
Therefore, firms doing business in many countries need to take into account the accounting system under which the firm’s financial statements are to be prepared.
FIFO vs. LIFO: Quick Comparison
|
Factor |
FIFO |
LIFO |
|
Cost assigned to sales |
Older inventory costs first |
Newer inventory costs first |
|
Ending inventory |
Generally reflects newer costs |
Generally reflects older costs |
|
Rising-price environment |
Usually lower COGS |
Usually higher COGS |
|
Rising-price gross profit |
Usually higher |
Usually lower |
|
IFRS |
Permitted |
Not permitted |
|
U.S. GAAP |
Permitted |
Permitted, subject to requirements |
When Should a Business Use FIFO Inventory Management?
FIFO may be especially useful when the natural flow of goods is in line with the oldest-in-first-out policy. FIFO may also be useful when the management wishes the ending inventory valuation to be based on more recent costs.
FIFO for Food, Pharmaceuticals, and Perishable Goods
For firms dealing with goods with expiration dates, there is an operational need to sell off old stock first. Food stores, food distributors, drug firms, and other firms require inventory management systems that minimize their stock losses from spoilage or becoming expired.
It is essential to understand the difference between inventory rotation in reality and accounting cost flow assumption. While one firm uses physical inventory rotation using the FIFO approach, it could be using another cost flow assumption for accounting purposes.
FIFO for Retail and Manufacturing
The retail sector can adopt inventory control measures that favor the FIFO system, thus avoiding instances where items become obsolete or outdated. These measures would especially apply to seasonal merchandise, fashionable goods, electronic gadgets, and others where there may be changes in demand or relevance.
There are ways through which manufacturers can implement their inventory control practices to determine old stock. If an organization has huge or complicated inventory, barcode technology, inventory software, warehouse control measures, and physical counting could enhance the FIFO process.
Benefits and Limitations of FIFO
There are some real-world benefits of using FIFO accounting. This approach is easy to understand, can correspond with the actual flow of goods in many cases, and will typically result in the most recent cost being in ending inventory.
However, FIFO may not always be the best approach to use. In situations where costs are on the rise, it may cause COGS to be reduced, thereby increasing net income. This is especially problematic when taxes are based on the accounting system used.
|
Advantage |
Business impact |
|
Simple cost-flow concept |
Easier for many businesses to understand |
|
Newer costs remain in inventory |
Ending inventory may better reflect recent purchase costs |
|
Works well with physical stock rotation |
Useful for products subject to expiration or obsolescence |
|
Recognized under major accounting frameworks |
Supports compliant financial reporting when properly applied |
How to Implement FIFO in Your Business
FIFO’s success does not simply entail the classification of inventory into “old” and “new.” Companies must have a method for recording the amount purchased, cost per unit, sales, returns, and balance inventory.
Organize Inventory by Purchase Date and Cost
Always document all inventory purchases by including the date, quantity, and price per unit of each purchase. Firms need to recognize the inventory leftover from each purchase group.
In the case of tangible goods, warehouse staff may employ any labeling or coding that makes the older inventory identifiable. From an accounting standpoint, it is also important for the inventory documentation to include cost data.
Use Accounting and Inventory Software
It is possible to make the task of tracking inventory simpler through the use of modern accounting and inventory management software programs since the company can keep track of purchases and sales through electronic recording.
However, automation does not take care of everything, and firms have to make sure that their system records are reconciled with actual inventory from time to time and document any discrepancies.
Review COGS and Inventory Regularly
Revisiting COGS, inventory levels, gross profit margins, shrinkage, and obsolete inventories is necessary for identifying any abnormalities. Companies must reconcile inventory accounts with their general ledger and address any significant variances. In case of expansion in an organization, hiring professional accountants will assist in implementing controls on inventories, evaluating the costing process, and preparing financial statements.
Professional accounting services can be particularly useful when internal accounting teams do not have sufficient time and knowledge to deal with complicated inventory records.
Inventory valuation through the FIFO method is one that offers a systematic way to allocate costs to inventories on the basis of the principle that the earliest costs of inventory will be recognized in the COGS. This method is useful in cases where there are perishable, seasonal, or obsolete inventories.
However, one needs to consider the industry, characteristics of inventory, accounting system, taxation and reporting requirements of the business while making an evaluation of the usefulness of this inventory costing method.
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