Inventory accounting can get complex fast. Different inventory accounting methods can change how your business views valuations, tax obligations, seasonal shifts and profitability as a whole. The First-In-First-Out or FIFO inventory method can cut some of this complexity to give your business a logical understanding of your financial health. By matching actual inventory movement and sales, FIFO enables straightforward tracking and crystal clear financial reporting. Learn how the FIFO method can be applied to your inventory strategy and when to use it.
The FIFO Inventory Method Explained
The FIFO inventory method uses the assumption that the items first added to your inventory are also the first to be sold. This approach reflects the natural flow of goods in many businesses, making it a logical choice for inventory valuation and the calculation of cost of goods sold (COGS). This inventory accounting method is especially relevant in retail businesses and in consumer goods businesses where perishable goods are often sold off first.
The Importance of FIFO in Inventory Management
FIFO offers a transparent and intuitive system for inventory management, aligning the physical flow of goods with financial records. This method has several benefits:
- Higher inventory valuations: In inflationary environments where earlier inventory costs are lower, remaining inventory is valued higher, which is beneficial for valuation, lending and more.
- Tax advantages: In deflationary environments where inventory costs decrease over time, earlier purchases with higher costs result in higher COGS, lowering the taxable income.
- Simplicity: Because this method matches the realistic flow of inventory, it’s easy to understand, accurate and simple to calculate.
- Seasonality: The FIFO inventory method reflects seasonality inventory flow, in which businesses are likely to sell their oldest inventory first due to trends or demand.
A Guide to Calculating Cost of Good Sold Using FIFO
To compute COGS under FIFO, follow these steps:
- Identify the costs associated with the earliest purchases still in inventory.
- Determine the total number of units sold during the period.
- Assign the cost of the earliest acquired items to the sold units, progressing chronologically through purchases.
- Sum the costs attributed to the sold units to determine the COGS for the period.
Practical Example: FIFO Calculation
Let’s illustrate the FIFO method with a simple example:
A bookstore begins the year with 100 books in stock, purchased at $10 each. During the year, it makes two additional purchases:
- 50 books at $12 each in June
- 40 books at $15 each in November
If the bookstore sells 120 books throughout the year, the COGS calculation under FIFO would work like this:
- Start with the earliest inventory: 100 books at $10 = $1,000.
- Move to the next purchase: 20 of the 50 books purchased in June at $12 = $240.
The total COGS for the 120 books sold would be: $1,000 (from the initial inventory) + $240 (from the June purchase) = $1,240.
FIFO vs. LIFO: Key Differences on Your Financial Statements
While FIFO assumes that the oldest inventory items are sold first, the last in, first out (LIFO) method posits that the most recent purchases are sold initially. How does this difference reflect in your financial statements or financial strategy?
- Income statement impact: LIFO deducts the most recent costs on the income statement. So, as inventory costs rise, LIFO reflects higher COGS and lower margins, which has important tax advantages.
- Balance sheet impact: If the LIFO method reflects older, lower inventory costs on the balance sheet, this can downplay inventory asset value relative to present day costs.
Steps for Adopting FIFO in Your Business
While the FIFO method is generally more straightforward, it should be implemented with care, especially with the help of an experienced accounting professional. For lean businesses, a fractional accounting expert can help you identify and set up the best inventory accounting method for your business.
Work with your accounting personnel or a part-time expert to take the following steps:
- Evaluate your needs: Review inventory methods against your business model to determine the implications of using the FIFO inventory method, from tax to logistics. Remember that you cannot change your inventory method in the middle of an accounting period, and you may need to apply for this change with the IRS or update old financial statements to reflect the new method.
- Optimize processes: Adopt the right inventory software and regulatory controls to develop an efficient, accurate and compliant process for tracking and costing inventory.
- Analyze trends: Assess changes or trends uncovered from your inventory accounting method, ensuring this method is appropriate. An accounting professional can also recommend ways to lower costs, adjust pricing or change your inventory strategy to better position your business.
Take Advantage of the FIFO Inventory Method
The FIFO inventory method offers a logical and transparent approach to inventory management, aligning closely with the physical flow of goods in many businesses. With the support of fractional finance and accounting professionals, businesses can further simplify their accounting as it relates to inventory. Paro’s elite network of fractional accounting experts can provide your business with the on-demand support you need to accurately track, account for and report on your inventory. Match with an expert and get started in just days.
