First in First Out (FIFO)

The FIFO method, which stands for "First In, First Out," is an asset-management and valuation approach where the assets acquired or produced first are the ones sold, used, or disposed of first. This method assumes that the oldest costs are reflected in the Cost of Goods Sold (COGS) on the income statement.
EXPLORE FUNDS
What is First in First Out (FIFO)
EXPLORE FUNDS
3 min
09-October-2024
First In First Out (FIFO) is an inventory management and accounting method, based on the fact that goods procured first are sold or consumed first. Many businesses also use this method to ensure the proper flow of inventory and for accurate financial reporting. FIFO is very handy when products have a limited shelf life, or market prices tend to change quickly. This article will cover what is FIFO or First In First Out - meaning, how this system works as well as, its pros and cons and how companies benefit from it.

What Is the FIFO method?

The First in the First Out (FIFO) method is a basic inventory accounting technique and financial management based on a systematic approach. FIFO is based on selling those items first, that are purchased or produced first. This way, older inventory gets sold out before newer stock comes in — critical for reducing the risk of obsolescence or spoilage — especially prevalent across food and pharma industries, hence highly suitable when dealing with perishables.

FIFO serves not only as an inventory management tool but also entails accounting implications such as in the computation of Cost of Goods Sold (COGS) or value of the inventory at hand, which have downstream impacts across financial statements and tax computations.

Key takeaways

  • FIFO helps in ensuring the flow of inventory is smooth and reduces obsolescence risk.
  • It impacts the cost of goods sold and ending inventory valuation in financial statements.
  • FIFO has a high potential to impact taxes, especially during inflation periods.
  • FIFO implementation works well with organizations dealing on a regular basis in perishable goods or inflation affects inventory over time.

FIFO formula

The formula for FIFO is easy and mainly focuses on the usage or sales of inventory in the sequence it happens in. The formula is as follows:

FIFO Cost of Goods Sold (COGS) = Cost of Oldest Inventory Items × Quantity Sold

This formula makes sure that the cost incurred with respect to the oldest inventory is recorded first. This aligns with the FIFO principle. The valuation of the inventory left over is then impacted and the COGS is reported in the financial statements of the company.

How to calculate FIFO?

First In First Out is calculated by identifying the oldest inventory units with their cost and then allocating this cost to the first items sold. The steps include:

  • Identify the oldest inventory: First, you identify which inventory was bought or manufactured first and calculate its cost.
  • Determine quantity sold: Now calculate how many quantities of items were sold during that period.
  • Apply FIFO formula: Apply the FIFO formula now, which is multiplying the total sold units by the cost of the oldest inventory. This will give you COGS.
  • Value remaining inventory: Now subtract the inventory sold from the total inventory to get the value of the stock that remains.
Companies can easily calculate COGS by following this method and the remaining inventory’s value with FIFO.

Understanding FIFO calculation with an example

Say a particular business or company’s purchases look like this:

  • January: 100 units at Rs. 200 each
  • February: 150 units at Rs. 250 each
  • March: 200 units at Rs. 300 each
Suppose in April, the company sells 250 units then the FIFO calculation would be:

  • For the first 100 units sold: 100 × Rs. 200 = Rs. 20,000
  • For the next 150 units sold: 150 × Rs. 250 = Rs. 37,500
Total COGS = Rs. 20,000 + Rs. 37,500 = Rs. 57,500

The inventory that remains would be:

March: 50 units at Rs. 300 each = Rs. 15,000

Therefore, in the above example, the COGS of the business is Rs. 57,500 while the remaining inventory is valued at Rs. 15,000.

How first in first out works?

The FIFO method follows the principle that things that are added first to the inventory of a company will be the first ones to be sold or used. This method works especially well in industries with rising inventory costs because it means that the oldest items, which were likely cheaper, get recorded as COGS first, reducing taxable income. In fact, through FIFO the organization can always maintain fresh goods and it also helps to reduce wastage if you are dealing with perishables.

What are the advantages of FIFO?

  • Reduces obsolescence: One of the big advantages of First In First Out (FIFO) is preventing obsolescence as in many cases the old inventory will be sold first.
  • Aligns with the actual flow: This method is most suitable for industries which require a good physical flow of goods, like the food and pharmaceutical industry.
  • Simplifies accounting: FIFO makes the accounting procedure simpler by attributing the oldest costs to COGS.
  • Accurate financial reporting: At the time of inflation, FIFO will present low COGS and high ending inventory value that can be useful for your financial statements.
  • Compliance: Financial standards like IFRS and SEBI universally accept FIFO.
  • Inventory management: It helps in ensuring optimum inventory levels, automating the replenishment process and reducing the risk of selling outdated or expired products.

What are the disadvantages of FIFO?

However, while FIFO offers many benefits there are some drawbacks too:

  • Higher taxes: During inflation periods, FIFO can result in higher taxable income as the low-cost inventory (which is now worth more) will be used to calculate COGS meaning that profits are generally higher.
  • Increased record-keeping: With FIFO, you need to track the cost and date of each inventory purchase meaning there will be more record-keeping involved, if your business has many transactions with its inventory this could be time-consuming.
  • Not suitable for all businesses: It is not recommended that FIFO be used in an industry where inventory costs tend to decrease over time since it would misrepresent what the cost structure looks like.

What type of business FIFO is best for?

  • Perishable goods: This method is ideal for organizations that handle fresh goods, like food and beverages where there are chances of items getting spoiled if not sold at the earliest.
  • Pharmaceuticals: The use of FIFO in the pharmaceutical sector ensures that medicines and other products are used before they expire.
  • Retail: FIFO is useful in retail businesses, especially fashion or electronics as it moves out older stock and prevents obsolescence.
  • Manufacturing: Manufacturers who work with perishable raw materials (chemicals or food ingredients) rely on FIFO to maintain quality at its best.

What type of business FIFO is not right for?

  • Non-perishable goods: FIFO can be difficult with non-perishables due to stable and declining inventory costs.
  • Bulk commodities: For businesses that carry bulk commodities like metals or grains where prices are volatile, FIFO may not reflect the true cost structure.
  • Industries with falling prices: In industries where the price of goods drops over time, such as technology companies, FIFO would result in higher COGS and lower profits

FIFO vs. LIFO

FIFO and LIFO (Last In First Out) are two completely opposite inventory management techniques. FIFO sells the inventory of the oldest purchase first, and LIFO sells the newest in. Due to rising prices of goods sold, however, FIFO generally makes for lower COGS that should directly translate into much higher reported profits. On the contrary, LIFO yields higher COGS and thus lower profits which then might be a good thing for tax purposes. Whether FIFO or LIFO is better for a company can depend on their financial strategy, the industry standards in which they operate and regulatory requirements.

Conclusion

FIFO or First in First Out is an advantageous inventory management method used by many businesses where goods have a limited shelf life and cost prices of stock fluctuate over time. With the FIFO inventory method, you can ensure that your business has fresh and relevant stock on hand and financial reporting that is easy and accurate. Regardless of whether you work in retail, are a manufacturer or the food industry following the First In First Out (FIFO) method will have significant benefits for your financial health and operational efficiency.

Some prominent platforms like Bajaj Finserv offer a range of handy tools and resources to ensure that businesses can keep their inventory under control while maximising benefits through the right financial strategies available.

Based on your financial goals, you can choose from a variety of mutual fund schemes and use their resources that make investing in mutual funds easy and hassle-free.

Frequently asked questions

Why is FIFO important?
First In First Out (FIFO) is significant due to the fact that it helps protect businesses from obsolescence and spoilage by selling older inventory prior to newer stock. They also offer more accurate financial reports, which is important, especially in times of inflation.

What are the advantages of using FIFO?
FIFO results in better inventory management, helps comply with accounting standards and results in more accurate financial reporting as obsolescence risk is reduced to a minimum.

Are there any disadvantages of FIFO?
The biggest cons of FIFO are the likelihood of increased tax liabilities in times of inflation and greater administrative burden due to extensive record keeping.

How does FIFO affect financial statements?
From the accounting perspective, FIFO affects financial statements by reporting lower COGS and a higher ending inventory value during inflation leading to increased profits and taxable income.

How is FIFO different from LIFO (Last In, First Out)?
FIFO sells out of the oldest inventory first and LIFO sells off the most recent one first. FIFO is almost always considered the better option due to its ease of use and because it tracks inventory levels more accurately, but LIFO can come in handy when there is tax advantages associated with using this method.

Is FIFO accepted under all accounting standards?
Yes, FIFO is consistent with all major accounting standards making it one of the most accepted methods globally.

How does FIFO impact tax calculations?
FIFO in periods of inflation can create a higher taxable income because the oldest, cheapest inventory is used for calculating the cost of goods sold which increases net profits.

What industries commonly use FIFO?
FIFO is used heavily in the food and beverage, pharmaceuticals, retail and manufacturing industries - in situations where keeping a product fresh for as long as possible becomes part of legal requirements.

What are some challenges in implementing FIFO?
Problems with FIFO implementation include accurate account keeping, processing high volume inventory transactions and meeting the accounting standard.

How does FIFO impact pricing strategies?
FIFO may affect pricing strategies as it would cause the price of cost goods sold to be similar with older inventory costs, hence change in costing prices subsequently results in a need for higher pricing.

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