First in First out, also known as the FIFO inventory method, is one of five different ways to value inventory. FIFO assumes that the oldest items purchased are sold first. FIFO is best for businesses that sell perishable food/drink items or products that have an expiration date like certain medications.
In this article, we will discuss how to calculate the value of inventory & the cost of goods sold using the FIFO method; as well as the advantages and disadvantages of using the FIFO inventory method.
How The FIFO Inventory Method Works
As I mentioned, the FIFO inventory method assumes that the oldest items put into inventory will be sold first. For example, let’s assume a grocery store receives 50 units of milk on Mondays, Wednesdays and Fridays. If I walk into that store to purchase a gallon of milk on Friday, my milk will most likely come from the Monday delivery, since that is what was put on the shelf first.
With the FIFO inventory method, the store would correlate all milk sales with the Monday shipment until 50 units runs out— even if a customer reaches to the back and grabs a fresher carton. This may sound nuanced, but it becomes very important when prices fluctuate from the supplier; e.g. if Wednesday’s shipment costs more than Monday’s shipment, due to inflation or market fluctuations.
The FIFO method differs from the LIFO method, which assumes that the newest items purchased will be sold first. Check out our article on the LIFO inventory method to learn more.
What Type of Business FIFO Is Best For
If your business sells perishable items and sells the oldest items first, then FIFO will give you the most accurate calculation of your inventory and sales profit. This includes retail businesses that sell food or other products with an expiration date like medication.
However, even businesses that don’t fit this description may want to use FIFO for the following reason: Under the FIFO method, the inventory that remains on the shelf at the end of the month or year is valued at a cost that is closer to what the current price is for those items (assuming that costs continue to rise). This would yield a strong balance sheet report because your assets would potentially carry a higher value under the FIFO method than they would under the LIFO method.
Your profit and loss report would also reflect a higher profit under the FIFO method than LIFO. While this could result in a higher tax bill, you still may want to consider using the FIFO method because it would show a stronger financial position to potential investors and lenders than if you used the LIFO method.
Advantages/Disadvantages of Using the FIFO Method
Some advantages to using FIFO inventory method are:
- FIFO results in a lower cost of goods sold number. This is due to the fact that older items generally tend to carry a lower cost than items purchased more recently, due to potential price increases.
- A lower cost of goods sold number will result in a higher profit.
- QuickBooks Online Plus uses FIFO to value inventory. If you are currently using QBO or are in the market for an accounting software, we recommend QBO to small businesses. Be sure to check out How to setup and track inventory in QuickBooks to see how this works.
A couple of disadvantages to using FIFO Inventory Method are:
- A higher tax bill. Since FIFO results in a higher profit, you will most likely pay more taxes as a result.
- There is no guarantee that the oldest items will be sold first, which could result in product reaching its expiration date before it is sold. This is something many grocery stores experience due to people like myself that pull their milk from the back and not the front of the shelf.
How To Calculate Inventory Value Using the FIFO Method
Going back to our grocery store example, let’s assume that we have the following gallons of milk are in stock:
Current Inventory: 100 gallons at $2 each = $200.00
Our total inventory value for milk is $200. Now let’s say that we make the following purchases of milk:
Purchase #1: 10 gallons at $2.50 each = $25.00
Purchase #2: 20 gallons at $3.00 each = $60.00
Our new inventory value is 130 gallons (100+10+20), valued at $285.00 ($200 +$25+$60)
Since inventory is an asset, the milk would appear on the balance sheet report, in the assets section with a value of $285.00. However, you’ll also need to account for the different cost “layers” you paid for the product.
How To Calculate Cost of Goods Sold Using the FIFO Method
So let’s continue with our milk example and assume that we have sold the following gallons of milk:
Week 1 – Sold 50 gallons
Week 2 – Sold 60 gallons
The Cost of Goods Sold would be calculated as follows for each week:
Week 1 – 50 gallons X $2 = $100.00
Cost of Goods Sold = $100.00
For Week 1, All sales for this week ( 50 gallons) was pulled from our current inventory of 100 gallons which was purchased at $2 per gallon.
Week 2 – 50 gallons @ $2 = $100.00
10 gallons @ $2.50 = $25.00
Cost of Goods Sold = $125.00
For Week 2, sales for this week were pulled from the remaining inventory stock of 50 gallons at $2 plus purchase #1 (above) at $2.50.
Bottom Line on FIFO Method
While it’s good to have a basic understanding of how to use the FIFO inventory method, I strongly recommend using an accounting software like QuickBooks Online. It will automatically do all of these tedious calculations for you in the background in real time.
This will ensure that your balance sheet will always be up-to-date with the current value of your inventory and your profit and loss statement will always be updated with the most recent cost of goods sold and profit numbers.