On paper, figuring out profit for a small business is easy. You take your revenue minus expenses, and voila! Profit. But in reality, it’s not that simple. Every time you purchase inventory, prices can vary.
So how do you know which price to use when you do your accounting?
You need to pick an inventory accounting method, and one of the most popular ones is the FIFO Method. But what, exactly, is the FIFO method? And when should you use it? We’ll cover all that and more, so let’s dive in!
What is the FIFO Method?
FIFO stands for the First In, First Out method of inventory management, which assumes that the first products you purchase are the first ones you sell. In other words, FIFO means the oldest items on your shelf are the first to go.
The FIFO method gives you a way of calculating your cost of goods sold and figuring out how much the rest of your inventory is worth.
Whether or not you actually sell your items in that order doesn’t matter as long as you use that approach for figuring out your cost of goods sold, gross profit, and inventory value. That way, all your inventory will be accounted for in the same way. The most important thing is to stay consistent.
Why Use FIFO?
FIFO is the most widely used method for inventory accounting. It requires less recordkeeping and gives you a better picture of how your costs affect your gross profit.
Why is that? Because most businesses sell older goods first. So FIFO is the best way to reflect that reality.
How To Use FIFO
You can use FIFO to figure out how much it costs to make the items you sell (i.e., cost of goods sold or COGS) and your gross profit. First, you’ll multiply the cost of your oldest inventory by the number of units sold.
For example, suppose you own a store that sells specialty candles, and your last two inventory orders are as follows:
Now, let’s say you sold 110 candles for $20 a piece today, giving you a total revenue of $2,200 for the day. Here’s how you would calculate your cost of goods sold (COGS) using FIFO.
You’ll assume that the first 100 candles came from the first batch, and the remaining 10 came from the second.
COGS (using FIFO) = (100 x $5) + (10 x $7) = $570
Then, you can calculate your gross profit, which is revenue – cost of goods sold. When you plug the $570 cost into your profit formula, you get:
Gross Profit = Revenue – Cost of Goods Sold
Gross Profit = $2,200 - $570 = $1,630
This means that you generated $1,630 of profit by selling 110 candles.
Inventory Valuation With FIFO
Besides calculating COGS, you can use the FIFO accounting method to calculate the value of your remaining (unsold) inventory, also known as inventory valuation. In that case, you’ll multiply what you have left by the most recent price you paid your suppliers.
Returning to the example above, you have 40 candles remaining in inventory—the 50 candles purchased in batch two minus the 10 you sold from that batch. You can calculate your ending inventory balance using the FIFO method as follows:
Inventory Value (using FIFO) = Number of Remaining Units x Most Recent Unit Cost
Inventory Value (using FIFO) = 40 x $7 = $280
Keep in mind that you should be consistent with your inventory accounting method. If you use FIFO for calculating COGS, you should also use it for inventory valuation.
FIFO vs. LIFO
When using FIFO, you assume that the first items (i.e., oldest items) you buy are the first ones you sell. On the other hand, the LIFO inventory valuation method uses the opposite cost flow assumption: Last In, First Out. In other words, if you use LIFO, you assume the newest items you bought are the first ones you sell.
The LIFO method is helpful for businesses whose prices are more subject to inflation, like grocery stores, convenience stores, and pharmacies. In these businesses, production costs rise steadily instead of fluctuating up and down.
If your costs are always increasing, the cost of the recent inventory items is higher than the older inventory. So you’ll get a higher cost of goods sold using LIFO than FIFO, since your recent purchases will be more expensive. Why does that matter?
A higher COGS can lower your gross profit, which in turn, can lower your taxable income. So, it may behoove you to use LIFO if you’re dealing with inflation.
How To Use LIFO
Let’s try LIFO for the same candle company that sold 110 units for $20 each. We will use the cost of the most recent batch first, which means that 50 of the candles cost $7 each. And the remaining 60 will be priced at $5.
COGS (using LIFO) = (50 x $7) + (60 x $5) = $650
The LIFO method gives us a COGS of $650, whereas FIFO gives us $570.
So why does this difference really matter? The answer comes down to the gross profit calculation.
If you calculate gross profit using the higher COGS of $650, you get:
Gross Profit = Revenue – COGS
Gross Profit = $2,200 – $650 = $1,550
The LIFO method has lowered your gross profit from $1,630 to $1,550. While this may sound bad, it’s not necessarily. This lower gross income lowers your business taxes.
For that reason, the LIFO method is not allowed in countries that adhere to the International Financial Reporting Standards (IFRS). But in the U.S., businesses follow the Generally Accepted Accounting Principles (GAAP), which says you can use the LIFO method for inventory accounting.
Finally, you can also use the LIFO accounting method to calculate the cost of inventory left over. In this example, that would be:
Inventory Value (using LIFO) = Cost of Older Inventory x Number of Unsold Units
Inventory Value (using LIFO) = 40 x $5 = $200
What Are the Downsides of Using FIFO?
Since FIFO is easier to use and more widely accepted, it’s a more popular inventory bookkeeping method compared to LIFO. But it does have a couple of potential downsides:
- Doesn't reflect inflation: If you’re in an industry where prices steadily rise, using the First In, First Out method might underestimate your cost of goods sold. When you subtract a lower cost of goods sold from your revenue, you have a higher gross profit, and higher profits can increase your business taxes. In other words, FIFO may give you a higher profit calculation, which can increase your taxes.
- Harder to gauge profit: Since you’re not tracing the costs of each specific inventory batch, it can be harder to figure out your exact profit. You’re assuming you sell the oldest inventory first, but that might not be the case. If you want exact profit numbers, you would have to keep track of each inventory batch and when you sell an item from it, but that’s not feasible for every business. That’s why many business owners choose a cost assumption method like FIFO or LIFO.
Other Valuation Methods
Besides FIFO and LIFO, there are two other inventory management methods available to you. They are average cost valuation and specific inventory tracing.
Average Cost Valuation
Average cost valuation uses the average cost of all your batches to determine the COGS for each unit. Compared to FIFO and LIFO, it is slightly easier since you’ll use the same COGS calculation for each unit sold.
But it’s not appropriate for all types of products. It can be especially misleading if you have several different types of products with varying production costs. For instance, if you sell two items and one costs $2 to produce while the other costs $20, the average cost of $11 doesn’t represent either cost very well.
Average cost valuation can be useful for companies that sell a large volume of similar products, such as cell phone cases. It’s not, however, allowed by the IRS for tax purposes.
Specific Inventory Tracing
Specific inventory tracing, also known as the specific identification method, is the most involved and time-consuming method of all four since it involves using the actual COGS for each product sold. It can only be used when you know the price of all components of a product and can trace their costs.
A business that would benefit from this method would be car dealerships. They have a limited inventory, and each car has different features and specifications that affect its cost and price. In that case, it’s easier to trace the cost and revenue of each particular unit.
Inventory Accounting and Your Financial Statements
Calculating the cost of goods sold helps you understand the relationship between costs, revenue, and profit. For business owners, this information is helpful in planning for the future, forecasting sales, and making decisions about products and pricing.
But inventory accounting isn’t just for your own good. It’s a necessary step in calculating your business income taxes and preparing financial statements.
Specifically, you’ll need to calculate the value of unsold inventory to list it as an asset on your balance sheet. As for your total cost of goods sold, that’s a line on your income statement, which helps you figure out how much of your revenue counts as gross profit.
Choosing a Cost Accounting Method
In total, there are four inventory costing methods you can use for inventory valuation and management. Of the four, FIFO is by far the most widely used. It’s accepted by both U.S. and international accounting standards, and it helps businesses figure out how much they’re spending on production.
You’re free to choose the inventory system that works best for your business, but the GAAP requires you to be consistent. In other words, if you choose FIFO, you have to use it for COGS and inventory valuation. And you also have to use the same method for future accounting periods.
If you want to change from one inventory valuation method to another, you have to obtain permission from the IRS by filing Form 3115, Application for Change in Accounting Method.
Now that you know all there is about FIFO, all that’s left to do? Pick the method that works for you and get to work tracking your profit.
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