First in first out (FIFO) method

A core element of good inventory management is accurately tracking the inventory’s value over time. The first-in, first-out method, or FIFO, is the most common method of tracking inventory.

The first in first out method, or the FIFO method, is a common inventory tracking strategy in which the oldest inventory is the first to be sold. This strategy minimizes the amount of time inventory is held in a warehouse. 

Following the FIFO method can help ecommerce and direct-to-consumer brands maximize profits. It aligns business costs with the actual movement of goods in and out of the fulfillment center and demonstrates the value of on-hand inventory for accounting purposes.

FIFO as it pertains to warehouse management most often applies to businesses dealing in perishable goods or those that may depreciate quickly, like apparel that may go out of style or technology that may become obsolete; however, as an accounting method, it applies to and is used by businesses with shelf-stable products as well. 

It’s important to note that because FIFO is primarily used as a tracking tool, not all businesses that use the first in first out method actually sell the oldest inventory first; in some cases, this is only an accounting method.

The most obvious benefit of using the FIFO method applies to businesses that sell perishable goods: moving the oldest inventory first keeps products from expiring before they can be sold. 

More broadly, FIFO makes for more accurate record keeping and higher profits. Because inventory is an asset, you, as the business owner or operator, are responsible for calculating the cost of goods sold, or COGS, at the end of each accounting period. You’ll also need to calculate the value of ending inventory—the sellable inventory left at the end of the accounting period. The ending inventory value impacts your balance sheets and write-offs. 

The strategy behind FIFO assumes that inflation is constant, meaning more recent inventory purchases will always cost more than older purchases. In other words, the inventory you purchased six months ago at $3 per unit may now cost $4 per unit. By selling the less expensive inventory first, the value of your ending inventory will be higher, since it will be calculated using the $4 purchase price. 

Here are some other core benefits of FIFO:

• Stockout and overstock risks are lower since FIFO helps maintain accurate inventory levels.
• The risk of financial losses due to obsolescence or spoilage is greatly reduced.
• Inventory spends less time overall in storage, reducing inventory holding costs.

Here’s an example of how the FIFO method tracks inventory value:

Let's say a candle company purchased 100 jar candles with a Crisp Apple scent from its manufacturer for $4 per unit. The scent was popular, so the company later placed a bigger purchase order for 200 candles—but the price per unit had risen to $5 per unit. 

That would mean the company had 300 total candles. Now let’s say the company sold 120 candles. 

Following the first in first out method, the company would assume the first purchase order is completely sold out, and 20 units of the second order have been sold. So, the company’s balance sheet would record the COGS like so: 

COGS = (total units sold from original purchase order x per-unit price) + (total units sold from second purchase order x per-unit price)

COGS = (100 x $4) + (20 x $5) = $500

The value of the ending inventory would then be the remaining units multiplied by their value: 

120 x $5 = $600.

Though it’s the most widely used, FIFO is not the only inventory tracking method. The most common alternative is last in first out, or LIFO, which focuses on selling the newest products first. The LIFO method assumes that the newest batch of inventory is sold first for accounting purposes as well. While it’s illegal to use LIFO in most countries, it’s an acceptable strategy in the United States.

Industries that experience significant price fluctuations or that must sell newer products first—like car dealerships—also use the LIFO method to reduce their tax liability. The COGS is higher because it’s calculated using newer inventory, which can lower the business’ net income, and therefore, its taxes.

Another option is the weighted average cost (WAC) method. This method takes all similar items in inventory, regardless of the purchase date, and applies the average cost per item to provide a cost of goods for sale at a specific point, such as the end of a quarter. Unlike LIFO, it is permitted by international standards. The WAC method may be used in continual or periodic inventory systems. This method can provide an accurate portrayal of all costs associated with a product, requires less paperwork, and uses a simple equation.

The main drawback to FIFO is you’ll likely pay higher taxes that correspond to a higher profit. Because the cost of goods generally increases over time, businesses using FIFO will benefit from today’s sale price and yesterday’s COGS. In other words, when you sell something today and apply your purchase costs from before, your profit will be maximized. 

In times of inflation when prices rise quickly and sharply, the cost of goods sold can differ from what appears on financial statements. And in times of hyperinflation, it can be hard to accurately show costs if supply prices keep rising quickly. Since the FIFO method makes profits look larger on paper, there is a larger tax liability.

There is a common misconception that FIFO is not for all industries and that it only applies to perishable foods and beverages. In reality, it can be used in any industry, since it’s primarily an accounting method. However, in industries where the cost of goods is more volatile, such as oil and gas, LIFO is more frequently used.