FIFO is the most commonly used of the three inventory management methods. FIFO — which stands for first in, first out — assumes that the oldest inventory is sold before the newer inventory. This inventory management method helps determine how much a business spent on goods, information important for completing tax returns, and is used to show investors a company’s profitability.
There’s a lot of jargon in the world of business and finance. It can definitely get overwhelming and confusing. One example of such jargon is the acronym FIFO. FIFO is a method used for cost analysis and inventory management. Using this method, a company can accurately determine how much it spent on goods. This amount is needed for tax reasons. It also shows investors how successful a company is.
This article outlines the FIFO definition, why the FIFO method is effective, and other methods a company may use in its place.
What is FIFO, and what does it stand for?
FIFO is an accounting method used by businesses to calculate the cost of goods sold. FIFO stands for “first in, first out.” Using the FIFO method, a person would calculate cost flow by assuming the oldest products in the company’s inventory were sold first. So, this means that the business theoretically sold its oldest products before selling its new inventory. It can be an excellent method of asset management.
What is FIFO used for?
FIFO is used for inventory management and represents the flow of inventory. FIFO assumes that whatever product was purchased first is sold first. The market value of products changes over time, so FIFO assumes that the oldest inventory was sold for older costs. These calculations are included on inventory statements.
Many different kinds of companies use the FIFO method, especially if they’re in the fashion industry or working with perishable goods. Warehouses, food services, florists, and clothing stores are among a few businesses that use this method.
Example of FIFO
Michelle’s flower company buys 100 roses for $1 each. A few weeks later, they buy another 100 roses, this time for $2 each. In another few weeks, the company purchases another 100 roses for $3 each.
Michelle’s flower company sells 150 roses. When calculating the cost of goods with FIFO, Michelle will include the roses they bought for $1 and $2, but not $3. With the FIFO method, it is assumed that the first 100 roses were purchased for $1, and the remaining 50 were purchased for $2.
Pros and cons of FIFO
There’s a reason FIFO is a method commonly used by many organizations. It does, however, have its shortcomings. Here are a few reasons why FIFO is the preferred method and a few reasons why other methods might be preferred.
Here is a list of the benefits and drawbacks to consider.
- The FIFO method is easy to understand.
- It’s a quick way to calculate the cost of goods.
- FIFO is the method most often preferred by organizations and it is the most widely used.
- Manipulation of financial statements is difficult to do under FIFO.
- It shows an increase in gross and net profits during times of high-cost inventory.
- Generally provides an accurate representation of the cost of goods.
- Since the gap between cost and profit is wide, using FIFO could result in higher income tax.
- May not be the best method in times of high inflation.
- FIFO could oversimplify things and may not account for the cost of transfer, supply and demand, and so on.
- Using FIFO means that clerical errors could occur.
How to calculate FIFO
Calculating FIFO is surprisingly easy. To do so, you multiply the cost of your oldest items by how many items were sold.
Here’s an example. Annie owns a small business and purchases 20 shirts for $5 each. The next month, she buys another 20 shirts for $6. Annie ends up selling 35 shirts.
To calculate the cost of goods, Annie would take the number of original units (20 shirts) and multiply them by the oldest cost ($5/shirt). Then, she would add the remaining units (15 shirts) times the newest cost ($6/shirt).
The formula she would use would be:
So, her cost of goods would be $190.
Confirming your formula
Note that if you include the units in your calculation, you can confirm that you’ve set up your formula correctly be checking that the units cancel properly. This can be useful if you ever find yourself foggy about what numbers should go where, such as when you are sleep-deprived with an urgent deadline to meet.
The above formula with units added is as follows:
Or, reduced to show units only:
When you multiple shirts by dollars/shirt, the shirt(s) units cancel out, leaving only dollars. Since dollars are what you’re calculating, it looks like you’ve set this formula up correctly. Good work!
In addition to making sure you multiply and add the right numbers together, there are some things you should remember when using the FIFO method.
FIFO method: how to avoid messing up
To err is easy. Here are four things to remember that will help you keep things straight:
- Keep fluctuating prices in mind when you calculate cost flow with this method.
- Do not include unsold inventory in the equation. Only account for sold goods.
- Remember to account for costs associated with the products (such as shipping). These may have to be calculated outside of FIFO.
- FIFO assumes the oldest assets were bought with the oldest costs for tax purposes.
Two alternatives to FIFO
Although very common, FIFO is not the only method that you can use. FIFO, LIFO, and the average cost method are the three techniques used when calculating the cost of goods. We’ll briefly describe the average cost method and LIFO here.
Average cost method
Rather than assign a different cost to each individual product, the average cost method assigns the same cost to each product. This method assumes that large volumes of inventory are similarly priced. The formula for the average cost method is the total cost of inventory divided by the total units of inventory.
If our earlier business owner, Annie, had used this method to calculate the cost of the 35 shirts see sold, her total inventory cost would have been $220 for 40 units of inventory, yielding an average cost per inventory unit of
Since she sold 35 shirts, the total cost of her sold inventory would be $192.50 (35 times $5.50) using this method.
LIFO is an acronym meaning last in, first out. While the method is similar to FIFO, the calculations are the opposite of FIFO. LIFO assumes that the latest items purchased are the first out. So, to calculate the cost of goods with the LIFO method, you would take the cost of your most recently purchased items and multiply it by the amount of inventory sold.
Here’s what the earlier business example would look like using LIFO instead of FIFO. Business owner Annie still purchases 20 shirts for $5 each, followed by another 20 shirts for $6, and still ends up selling 35 shirts.
To calculate the cost of goods, Annie would take the number of newer units (20 shirts) and multiply them by the newest cost ($6/shirt). Then, she would add the remaining units (15 shirts) times the older cost ($5/shirt).
The formula she would use would be:
So, her cost of goods would be $195 using LIFO.
Annie examples recap
To recap, here are the values business owner Annie got using each of the three methods:
|Method||Annie’s cost of goods sold|
The differences between FIFO and LIFO
Although both are used for inventory management, there are a few key differences between FIFO and LIFO. First, LIFO surmises that the latest items purchased are the first to be sold. Second, LIFO tends to be used for nonperishable goods, while FIFO is used for perishable items. Lastly, some companies choose to use LIFO over FIFO during times of high inflation for tax reasons.
More companies today prefer FIFO and are moving away from LIFO, for many different reasons.
FIFO over LIFO: key reasons
Here are some of the main reasons that companies choose FIFO over LIFO:
- FIFO tends to be easier to understand than LIFO.
- Most businesses are already implementing FIFO in their practices. Many companies already sell their older inventory first, so it just makes sense to use the FIFO method.
- LIFO can be easier to manipulate in financial records than FIFO.
- The LIFO method tends to show lower profits. While this is good for tax reasons, it does make the business seem less appealing to investors.
Because it is easy to understand and difficult to manipulate, FIFO has become the preferred method of asset management. You will find that more and more businesses are moving away from other methods and solely using FIFO. However, it can be difficult for an existing business to switch over to FIFO when it has already been using LIFO for some time. Regardless, the change might be worth the effort, as FIFO tends to be the more accurate and most accepted inventory management method.
When is it best to use FIFO?
FIFO is best to use in most situations, but especially when working with perishable goods. Industries that work with perishable goods are usually selling older inventory before newer inventory, making FIFO the most logical method.
FIFO is also recognized by the International Financial Reporting Standards (IFRS), while LIFO is not. So, if your business is international, you should use FIFO.
Trading and FIFO
Both LIFO and FIFO have their pros and cons when it comes to declaring the profits and losses of investments. The IRS uses FIFO by default. So, if you don’t specify what method you are using, the IRS will assume you are using FIFO. Both methods can save you money depending on your investment strategy and how your assets perform. The main advantage of FIFO is your profits are more likely to be taxed as long-term capital gains, which has lower rates than short-term capital gains. On the other hand, the shares you bought first are more likely to have a lower cost basis because stock prices usually rise over time.
You could save money by selling your most recently bought shares even if it does trigger a short-term capital gains treatment. The key is to calculate what makes sense in your case and talk to your brokerage. The brokerages below provide daily tax-loss harvesting to investors, which can help you save on taxes.
What does FIFO stand for in stock rotation?
FIFO means first in, first out in stock rotation. In this case, it means the oldest inventory is stocked on shelves and sold before the newer inventory. For example, a grocery store would sell milk that expires in two weeks before selling the milk that expires in three weeks.
What is FIFO in retail terms?
FIFO’s meaning in retail terms resembles its meaning in stock terms. A retail company may work to sell old inventory before it becomes obsolete. When calculating the cost of goods, it would use the FIFO method, meaning it would multiply the cost of the oldest inventory by the number of goods sold.
What is the FIFO method when speaking of product sales?
In terms of product sales, the FIFO method means selling older products first. Companies may choose to do this to prevent losing money and reduce waste. Selling newer inventory first could result in a build-up of unwanted and unsellable inventory.
- FIFO is used for determining the cost basis of inventory sold and stands for first in, first out.
- The FIFO method assumes that the oldest inventory is the first sold.
- To calculate the cost of goods using FIFO, you would take the cost of your oldest inventory and multiply it by the amount sold.
- The cost of goods is used for investing and tax reasons.
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View Article Sources
- Average Cost Method for Inventory Management and Accounting — Indeed
- FIFO accounting — Legal Information Institute, Cornell University
- Fifo/Lifo/Average Cost: Who cares? — Taylor S. Klett, CPA, JD
- FIFO vs. LIFO: What Is the Difference? — Business News Daily
- GAAP vs. IFRS: What Are the Key Differences and Which Should You Use? — Harvard Business School
- LIFO accounting — Legal Information Institute, Cornell University
- Publication 538: Accounting Periods and Methods — Internal Revenue Service
- Relevant background reading from accounting, investing, software, personal finance, and business finance sites — Various
- 25+ Free Spreadsheet Templates To Manage Your Daily Finances Effectively! — SuperMoney
- Best Online Business Loans in 2022 — SuperMoney
- Business Loans – How Much Financing Do You Really Need? — SuperMoney
- Cost Basis: How To Track and Calculate It? — SuperMoney
- Funding Options to Finance The Purchase of An Existing Business — SuperMoney
- How to Finance a Business — SuperMoney
- How to Get Free Tax Help — SuperMoney
Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.