First-In First-Out FIFO Method

We will then have to value 20 units of ending inventory on $4 per unit (most recent purchase cost) and the remaining 3 units on the cost of the second most recent purchase (i.e., $5 per unit). Therefore, the value of ending inventory is $92 (23 units x $4), which is the same amount we calculated using the perpetual method. The inventory balance at the end of the second day is understandably reduced by four units.

Many companies choose FIFO as their best practice because it’s regulatory-compliant across many jurisdictions. We’ll explore how the FIFO method works, as well as the advantages and disadvantages of using FIFO calculations for accounting. We’ll also compare the FIFO and LIFO methods to help you choose the right fit for your small business.

What is the FIFO method?

This helps keep inventory fresh and reduces inventory write-offs which increases business profitability. The biggest disadvantage to using FIFO is that you’ll likely pay more in taxes 4 best monthly financial management report template than through other methods. This is because the cost of goods typically increases over time so when you sell something in the present day and attribute your COGS to what you purchased it for months prior, your profit will be maximized. FIFO is the best method to use for accounting for your inventory because it is easy to use and will help your profits look the best if you’re looking to impress investors or potential buyers.

1. As we will discuss below, the FIFO method creates several implications on a company’s financial statements.
2. Using the FIFO method, the cost of goods sold (COGS) of the oldest inventory is used to determine the value of ending inventory, despite any recent changes in costs.
3. For inventory tracking purposes and accurate fulfillment, ShipBob uses a lot tracking system that includes a lot feature, allowing you to separate items based on their lot numbers.

Through the software, we get real-time insight into how much inventory to allocate to a specific warehouse, our current on-hand inventory levels, and how long each SKU is going to last by location. ShipBob provides a lot of distribution metrics, and everything presented is useful. For example, say a rare antiques dealer purchases a mirror, a chair, a desk, and a vase for $50, $4,000, $375, and $800 respectively.

Con: Higher taxes

Under the FIFO method, the COGS for each of the 60 items is $10/unit because the first goods purchased are the first goods sold. Of the 140 remaining items in inventory, the value of 40 items is $10/unit, and the value of 100 items is $15/unit because the inventory is assigned the most recent cost under the FIFO method. To calculate FIFO, multiply the amount of units sold by the cost of your oldest inventory. If the number of units sold exceeds the number of oldest inventory items, move on to the next oldest inventory and multiply the excess amount by that cost.

Our example has a four-day period, but we can use the same steps to calculate the ending inventory for a period of any duration, such as weeks, months, quarters, or years. As we shall see in the following example, both periodic and perpetual inventory systems provide the same value of ending inventory under the FIFO method. Third, we need to update the inventory balance to account for additions and subtractions of inventory.

The opposite of FIFO is LIFO (Last In, First Out), where the last item purchased or acquired is the first item out. Average cost inventory is another method that assigns the same cost to each item and results in net income and ending inventory balances between FIFO and LIFO. Finally, specific inventory tracing is used only when all components attributable to a finished product are known. Learn more about the difference between FIFO vs LIFO inventory valuation methods.

On the third day, we assign the cost of the three units sold as $5 each. This is because even though we acquired 30 units at the cost of $4 each the same day, we have assumed that the sales have been made from the inventory units that were acquired earlier for $5 each. It takes less time and labor to implement an average cost method, thereby reducing company costs. The method works best for companies that sell large numbers of relatively similar products. Three units costing $5 each were purchased earlier, so we need to remove them from the inventory balance first, whereas the remaining seven units are assigned the cost of $4 each.

Other Valuation Methods

This means that when a business calculates its cost of goods sold for a given period, it uses the costs from the oldest inventory assets. As you can see, the FIFO method of inventory valuation results in slightly lower COGS, higher ending inventory value, and higher profits. This makes the FIFO method ideal for brands looking to represent growth in their financials. The average cost method, on the other hand, is best for brands that don’t see the cost of materials or goods increasing over time, as it is more straightforward to calculate. Therefore, it will provide higher-quality information on the balance sheet compared to other inventory valuation methods.

During inflationary times, supply prices increase over time, leaving the first ones to be the cheapest. Those are the ones that COGS considers first; thus, resulting in lower COGS and higher ending inventory. If COGS shows a higher value, profitability will be lower, and the company will have to pay lower taxes. Meanwhile, if you record a lower COGS, the company will report a higher profit margin and pay higher taxes. The first guitar was purchased in January for $40.The second guitar was bought in February for $50.The third guitar was acquired in March for $60. In a period of inflation, the cost of ending inventory decreases under the FIFO method.

The cost of the newer snowmobile shows a better approximation to the current market value. FIFO is also the most accurate method for reflecting the actual flow of inventory for most businesses. In normal economic circumstances, inflation means that the cost of goods sold rises over time. Since FIFO records the oldest production costs on goods sold first, it doesn’t reflect the current economic situation, but it avoids large fluctuations in income statements compared to LIFO. FIFO, or First In, First Out, is a method of inventory valuation that businesses use to calculate the cost of goods sold. FIFO is calculated by adding the cost of the earliest inventory items sold.

What Is the FIFO Method?

Using the FIFO inventory method, this would give you your Cost of Goods Sold for those 15 units. Good inventory management software makes it easy to log new orders, furniture and fixtures in accounting record prices, and calculate FIFO. Accounting software offers plenty of features for organizing your inventory and costs so you can stay on top of your inventory value. FIFO assumes that the oldest products are sold first, but it’s important to make sure that this practice is actually applied to your warehouse.

Finding the value of ending inventory using the FIFO method can be tricky unless you familiarize yourself with the right process. Learn more about what LIFO is and its impact on net income to decide if LIFO valuation is right for you.

Keep up with Michelle’s CPA career — and ultramarathoning endeavors — on LinkedIn. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Consider the following practices to ensure your FIFO calculations are accurate and up to date. With over a decade of editorial experience, Rob Watts breaks down complex topics for small businesses that want to grow and succeed. His work has been featured in outlets such as Keypoint Intelligence, FitSmallBusiness and PCMag.

During periods of increasing prices, this means the inventory item sold is assessed a higher cost of goods sold under LIFO. With this method, companies add up the total cost of goods purchased or produced during a specified time. This amount is then divided by the number of items the company purchased or produced during that same period.