- FIFO is short for First-In, First-Out. This accounting method can be used to work out the cost of goods sold in your inventory
- FIFO accounting is required in most major markets and is standard in many more
- Effortlessly create an effective delivery experience customers love with Easyship, allowing you to focus on efficient inventory management and increasing sales
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Are you looking to keep track of your inventory costs? This article breaks down what the FIFO method is, how to calculate FIFO for your store and the key differences from LIFO. Plus, how your business can benefit from applying this inventory accounting method and how Easyship can help you simplify shipping today.
What is FIFO?
FIFO is an acronym for the term First-In, First-Out. This is used for cost flow assumption purposes, the method in which costs are removed from a business's inventory and reported as the cost of sold products. FIFO is an assumption because the flow of costs of an inventory doesn't have to match the actual flow of items out of inventory.
This method values your inventory so that the business is less likely to lose money from products that can expire or become obsolete. This is especially useful for maintaining profits from perishable goods, as it makes sense to sell older inventory. It can also help protect from fluctuations in economic conditions and the potential for rapidly increasing cost of production.
Key examples of products whose inventory is valued on the assumption that the goods purchased last are sold first at their original cost include food or designer fashion. Any industry where demand can fluctuate will benefit from FIFO. Leaving the newer, more expensive inventory for a higher costs environment.
This can help increase net income. The inventory that might be old, which could have been purchased or produced at a lower inventory cost, is used to determine the cost of goods sold (COGS). When calculating COGS, this benefit can become clear:
COGS = starting inventory + purchases - ending inventory
How to Calculate FIFO With Example
To calculate COGS through the FIFO method, first you need to work out the cost of your old inventory. If the price you paid for that inventory fluctuates during that time period, this does need to be taken into account as well. Once you have that figure, you multiply the cost by the total amount of inventory sold in that period.
To break this down, check out the example below detailing how to calculate ending inventory using FIFO below:
- For an online store, 100 items cost the business $10.00 each to produce
- For the next batch, the cost has gone up to $12.00
- After 150 items have been sold, you want to check the COGS
- Since 100 items cost $10, the remaining 50 will have to use the higher $12 cost number
- This will achieve a COGS total you can use to calculate ending inventory
Related Post: Inventory Management Best Practices for Small Businesses
How Is It Different From LIFO?
While FIFO and LIFO are both cost flow assumption methods, the LIFO method is the opposite of the FIFO method. Standing for last in first out, this inventory valuation method doesn't sell the oldest items first and uses current prices to calculate the cost of goods sold. This is instead of the original cost of inventory purchases.
This method is best used for products that aren't perishable and experience price inflation. Key examples include nonperishable commodities like metals, car parts, pharmaceuticals, tobacco, petroleum and chemicals. In short, any industry that experiences rising costs can benefit from using this accounting method.
When prices are increasing, companies using LIFO can benefit due to tax purposes. This tax break occurs through lowering net income, subsequently lowering the total cost of taxes a business has to pay. This is because this inventory method assumes that the first items to be sold in that accounting period are the most expensive to produce.
Fun fact: The practice is banned in almost all markets under International Financial Reporting Standards, however LIFO is still permitted in the US.
Other Valuation Methods
While FIFO and LIFO are some of the most prominent valuation methods, there are others available. Check out this brief summary of how they compare to FIFO:
Average Cost Inventory
This method assigns the same cost to each item, by dividing the total cost of goods by the total number of items available for sale. This method is also known as the weighted average and is calculated over a specific time period. Simple to use, whether a business or purchasing or producing goods, the end net income is a balance between FIFO and LIFO.
Specific Inventory Tracing
When all components of a finished product can be tracked throughout their time inventory, this method can be used. However, if all items can't be individually tracked, then FIFO, LIFO or average cost would work best.
Advantages of using FIFO
There are some key benefits of FIFO that can apply to nearly all businesses that require inventory management:
- Easy to understand and implement
- Harder to manipulate income statements
- FIFO is required in some jurisdictions and is standard in many more
- Follows the natural flow of inventory for most businesses
- Reflects the current value of inventory better than LIFO
Disadvantages of FIFO
While FIFO is strongly encouraged or even required in many countries around the world, there are some downsides to be aware of when using this accounting method. Below, we summarize two key disadvantages:
- Tends to inflate the actual profit margin, especially during periods of high inflation. This creates misleading financial reporting, with gains looking larger than they are and costs appearing lower
- These misreported profits due to FIFO accounting can then lead to a business paying substantially more in tax
- Innovative businesses may have a different flow of inventory that is not reflected by FIFO
Automate Your Shipping Process With Easyship Today
Using FIFO accounting can help your store grow from a range of key benefits. From being straightforward to implement and required by many global markets, it can also follow your store's already-in-place inventory flow. Upgrading to an inventory management system can further simplify this process by adding visibility, allowing you to track, control and forecast your store's stock.
Easyship Shipping Dashboard: Manage all your orders so that you can reach customers worldwide. Take advantage of Easyship's powerful shipping automation tools and global warehouse partners.
Are you looking to keep track of your stock? Sign up for a FREE Easyship account and seamlessly keep track of order pickups on the go through the Easyship mobile app