First In First Out: What Is the FIFO Method?
When it comes to inventory management for retailers, one core component is inventory valuation. Inventory valuation is when you calculate how much your total stock on hand is worth at the end of a given period of time. Retailers then use this metric to calculate cost of goods sold (COGS), as well as report it on their balance sheet.
There are many different methods and approaches to inventory valuation, each with their own set of pros and cons. Let’s do a deep dive into the first in first out (FIFO) method and learn about the FIFO definition and if it makes sense for your growing business.
Table of Contents
- The difference between FIFO and LIFO
- FIFO example
What Is FIFO?
What does FIFO mean? FIFO, meaning “First In First Out,” is the acronym for the inventory valuation method. Though the FIFO acronym has a few different meanings, in retail, it mostly refers to inventory accounting and management.
What Is the First In First Out Method?
The First In First Out method, or FIFO method, is a cost flow assumption to value inventory. It follows the logic that the first item a business purchases is also the first item that business sells. It assumes that a retailer sells the oldest stock available for each purchase.
For the retailer’s accounting, this means that the oldest price paid for inventory is recorded when a product is sold. That price informs the cost of goods sold (COGS) metric until all inventory purchased for that amount has also been sold.
There are cases where this assumed flow of goods matches the retailer’s actual operations, but there are also instances where this isn’t how a retailer actually moves stock.
When it comes to tax reporting, the FIFO method assumes that any stock a retailer is holding will be matched to the unit costs of the first-acquired items.
The FIFO method is accepted by the U.S. Generally Accepted Accounting Principles (GAAP), which is the accounting standard of the Securities and Exchange Commission (SEC). Internationally, it’s acceptable to the International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB).
The Difference Between FIFO and LIFO
Have you heard of the LIFO method? LIFO, or Last In First Out, is essentially the opposite of the FIFO method. Under this cost flow assumption, instead of using the oldest-recorded inventory costs, retailers use the unit cost of the most recently purchased stock. They assume that the most recently purchased merchandise is also the first to be sold.
There are more differences between the FIFO method and LIFO that come from the outcomes of each approach to inventory control and retail reporting. You’ll often hear that LIFO is a more appealing approach because it reduces profit, which reduces taxes. This is because FIFO uses old unit costs, so the COGS is lower. But it also means that inflation rates are not accounted for. When there’s a significant amount of inflation, it can be challenging for retailers to estimate actual, up-to-date COGS and related metrics.
LIFO is only accepted in the U.S., and companies that use LIFO for inventory valuation and financial reporting must also use it for taxes.
Now that we understand the FIFO definition, let’s look at a FIFO example to demonstrate it. For the purposes of this FIFO example, let’s assume that you’re a retailer who owns a running store that sells running shoes and related gear at your brick-and-mortar store and online. We’ll also use one month as the reporting period for this FIFO example.
In week one, you order 300 units of a new pair of running shoes for $50 each.
In week two, you order 400 new pairs of shoes. The supplier has increased the price, and now you’re paying $60 a pair.
In week three, you sell 600 pairs of shoes for $150 each.
You have 100 pairs left. How much are those 100 pairs of running shoes worth?
Using the FIFO method, you’ve sold out of the 300 pairs of running shoes that you purchased in week one for $50/pair. The 300 that you sold during week three would be reported at the $60 unit cost. So your resulting inventory valuation would be 100 units * $60 unit cost = $6,000.
If we were to flip that scenario for the LIFO method, you’d assume that the 400 pairs of shoes you purchased during week two were the first ones sold, your unit cost being $60. The remaining 100 pairs of shoes would be 100 units * $50 unit cost = $5,000.
Why Is First In First Out Important for Retailers?
The first in first out method has many advantages for retailers, and some verticals benefit more than others. For the food and beverage industry, products expire more rapidly than in other niches. The FIFO method makes tons of sense in these scenarios, because oftentimes, inventory truly is moving in a first-in-first-out flow. Other brands that sell perishable products, such as drugstores, also function in a similar way.
Fashion is another vertical that particular benefits from the FIFO method. Trends go out of style at a rapid pace, and brands have to keep their inventory new and exciting to stay competitive. Seasonality also comes into play, and other retail brands with seasonal products or fluctuations also stand to benefit from a FIFO approach.
For brands looking to attract investors, the FIFO method is also especially advantageous. Because it increases profits compared to LIFO, your business will be in better financial health on paper — thus representing a more attractive investment opportunity.
Additionally, retailers that are looking to expand internationally won’t face any restrictions on the FIFO method. Because it’s a globally accepted reporting method, you’ll already be compliant in markets where you want to sell or possibly open a second location, warehouse or office space.
And because FIFO means that your oldest items are sold first, there are fewer historical records to maintain, which keeps your data cleaner and more manageable.
Recap: FIFO Meaning and How to Use It
Think you understand the FIFO definition and how to use the first in first out method for your business? Remember, it’s an internationally accepted standard for inventory reporting, unlike LIFO which is only accepted in the U.S.
Retailers that comprehend the FIFO meaning and its full benefits can keep stock fresh and stay profitable, making your brand appealing to both consumers and potential investors.