FIFO: Everything You Need To Know (2025)

Have you ever wondered how other stores keep track of their inventory? One popular option that they use is what we call FIFO. This method might also work if you are looking to test one.

But what is it? How does it work?

This guide will help you understand everything you must know about FIFO, what it stands for, and how it works in the real world.

Key Takeaways

• FIFO is an inventory management method in which the earliest items are sold or used first. This globally accepted method aligns with the natural flow of goods and accurately reflects current inventory costs.
  
  
• FIFO has its advantages and disadvantages. Its benefits are simplicity, inventory flow alignment, and improved financial statements. On the other hand, its drawbacks are higher taxes but limited benefits and a disconnect between book and market value.
  
  
• FIFO accurately reflects inventory costs and suits stable or rising prices. LIFO shows more conservative profits and is beneficial during inflation or fast-changing trends. The choice depends on the business context and economic conditions.
  
  

What Is FIFO?

FIFO is a concept used in inventory management and accounting. It assumes the earliest items you acquired or produced are also sold or used first.

For example:

Imagine a line at a store - the person waiting for the longest (first in) gets served first (first out). In inventory, it's similar! The oldest items should also be the ones sold first.

What Does FIFO Stand For?

FIFO stands for First In, First Out. It's a common inventory valuation accounting method used globally. It aligns well with the natural flow of goods in many businesses and follows international financial reporting standards, making it easier to enter the correct numbers.

This concept can provide a more accurate picture of current inventory costs than other inventory accounting methods.

How Do FIFO Inventory Valuation Methods Work?

The FIFO inventory valuation method works by assuming the cost of the first items you purchased (the ones that "came in" first) is the cost of the first items you sell (the ones that "go out" first).

Here's a breakdown of the process:

1. Inventory Purchases. Whenever you buy new inventory, you record the costs of those items separately. This file includes the quantity and total price paid.
   
   
2. Inventory Sales. When you sell an item, you determine the sale's cost by looking at your oldest inventory purchases. Imagine a stack of invoices for your inventory purchases. You would use the price from the top invoice (representing the earliest purchase) for the first item sold, then move down the stack to value subsequent sales.
   
   
3. Cost of Goods Sold (COGS). Using FIFO, you add the price of each good sold to determine the total COGS for a specific period.
   
   
4. Ending Inventory Valuation. After all sales are accounted for, the remaining inventory is valued using the costs of the most recent purchases that haven't been used yet. So, the ending inventory reflects the price of the newer items you still have on hand.
   
   

While FIFO is often associated with perishable items, it applies to other inventory valuation methods. Here's an analogy using non-perishable items:

Imagine you run a bookstore that sells novels. A new book by a popular author arrives. You buy 10 copies for CAD 10 each. A week later, the popularity exploded, and the publisher raised the price to CAD 12 per book. You order another 10 copies at the new price.

Following FIFO, when a customer buys a novel, you'd assume the average cost of the book sold is CAD 10 (from the first purchase batch). This applies even if you first sell a copy from the newer, more expensive batch. Those CAD 10 costs are added for each book sold to determine your COGS.

For your ending inventory, the remaining books on the shelf would be valued at CAD 12 each (reflecting the most recent purchase price). This way, your inventory valuation remains accurate and reflects current market costs.

Calculating COGS with FIFO:

1. FIFO Assumption. We assume the first novels sold are from the initial purchase.
   
   
2. COGS Calculation. Since you sold 5 novels, and each was CAD 10 (from the first purchase), the COGS for these sales is:

Calculating Ending Inventory Value:

1. Remaining Inventory. You started with 20 novels (10 + 10) and sold 5, so you have 15 remaining.
   
   
2. FIFO Assumption. The remaining novels are from the second, more expensive purchase.
   
   
3. Ending Inventory Valuation. Since you have 15 novels left, and each cost CAD 12 (from the second purchase), the total value of your ending inventory is:

With the calculation shown above, here's how you can draw the summary:

• You sold 5 novels with a COGS of CAD 50 (using the CAD 10 cost from the first purchase).
  
  
• You have 15 novels remaining, valued at CAD 180 total (using the CAD 12 cost from the second purchase).
  
  

This demonstrates how FIFO assigns costs to your inventory based on the order of purchases, impacting both your COGS and ending inventory valuation.

What Are The Pros and Cons Of Using The FIFO Inventory Valuation Method?

While FIFO offers many advantages, it's not without drawbacks. Let's explore both sides of the coin to understand when FIFO might be the best choice for your business.

Pros Of The FIFO Method

First, let us discuss the advantages of using the FIFO method.

Simple and Efficient

FIFO shines in its straightforwardness. You track your purchases and their costs according to the date you bought them. When you sell something, you assume the price is from the oldest purchase, like moving down a list.

This process eliminates complex tracking of individual items and makes record-keeping efficient. For many businesses, FIFO offers an accurate and easy-to-implement solution.

Align Inventory Flow

Imagine a store shelf. The new stock gets added to the back. Ideally, customers first grab the items at the front (the oldest ones). FIFO reflects this real-world flow. You record purchase costs as you buy inventory.

When calculating inventory before you make a sale, the price is assumed to come from the earliest purchase, like taking the front item off the shelf. This aligns with the natural order of inventory movement, making FIFO practical for many businesses.

Reduce Waste

FIFO helps combat waste, especially with perishable items. However, it can also indirectly reduce waste with non-perishables. Imagine a store with outdated phone cases. With FIFO, you focus on selling older stock first.

This process reduces the chance of newer cases sitting unused while older ones become obsolete due to design changes or new phone models. By pushing out the older stock first, FIFO helps businesses sell what they have and avoid getting stuck with unusable inventory.

Improve Financial Statements

FIFO can improve your financial statements in two ways.

1. First, it often aligns with the actual flow of goods, which means your ending inventory reflects more current costs. This feature can give a more accurate picture of the company's financial health.
   
   
2. Second, during inflation, FIFO can show higher profits due to using older, lower purchase prices for COGS. This benefit can make your business look more profitable on the balance sheet. However, it's important to remember this may not show true profitability and could lead to higher taxes.
   
   

Increase Business Valuation

The FIFO method can indirectly boost business valuation by inflating profitability during inflationary periods. Since FIFO uses older, lower costs for COGS, it leaves a higher net income on the financial statements.

This higher period reported profit can make your business more attractive to potential investors, potentially increasing its valuation. However, it's crucial to remember this inflated profit might reflect something other than true earning power.

Compliance

FIFO can champion compliance in industries with strict regulations. By first focusing on using older stock, FIFO helps ensure outdated or potentially unsafe items aren't sold. This aligns with rules focused on product safety and quality control.

Additionally, clear FIFO documentation demonstrates a systematic inventory management approach, smoothing audits by regulatory bodies.

Cons Of The FIFO Method

While FIFO offers many advantages, it is better suited for some situations. Let's explore some drawbacks when deciding if FIFO is the proper method for your business.

Misrepresentation During Inflation

FIFO can be a double-edged sword during inflation. While it shows higher profits from using older, lower purchase prices for COGS, this can be misleading. Imagine buying CAD 1 before inflation widgets and selling them for CAD 2 now.

FIFO would value your remaining inventory at CAD 1, not reflecting the current CAD 2 market price. This downplays the actual value of your inventory and might misrepresent your company's financial health.

Higher Tax Burden

FIFO's inflation advantage comes with a tax time sting. During rising prices, you use older, lower costs for COGS, leading to a higher reported net income. This might seem significant, but it means higher taxable income for your business.

Imagine buying shirts for CAD 5 each and selling them for CAD 10. With FIFO, your profit looks bigger because COGS reflects the CAD 5 cost. But, the taxman looks at your profit, not your purchase price, potentially leading to a higher tax bill than a method reflecting current expenses.

Limited Tax Benefits

FIFO's tax benefits are a mirage during inflation. While it shows higher profits due to using older, lower purchase prices, this translates to higher taxable income. Think of buying hats for CAD 10 before a price hike. You sell them for CAD 15 now, but FIFO says your COGS is CAD 10.

This inflates your profit on average cost inventory on paper. However, the taxman taxes your profit, not your purchase price. You might end up with a more enormous tax bill compared to using a method reflecting current costs. FIFO's tax "benefit" is a hidden tax burden.

Potential Disconnection Between Book and Market Value

FIFO can cause a disconnect between your inventory's book value (what it's recorded as) and its market value (what it's actually worth). Imagine buying shoes for CAD 20 each. Inflation hits, and the shoes now cost CAD 25.

With FIFO, your books show the inventory value at CAD 20. But if you try to sell the shoes, you'd likely price them at CAD 25 to reflect the market. This mismatch can distort your financial picture.

You might have profitable sales on paper (due to lower COGS from FIFO), but your inventory's actual value isn't reflected, potentially impacting essential business decisions.

Less Accurate Profit Representation During Deflation

During deflation (falling prices), FIFO can underestimate your actual profit. Here's why: Imagine buying hats for CAD 10 each. Now, there's a sale, and they're CAD 8. With FIFO, when you sell a hat, the COGS is still CAD 10 (from the older purchase).

This reduces your profit on paper compared to reality (selling for more than your current cost). Since FIFO uses older, higher costs, it inflates COGS, leading to a lower reported profit that might not reflect what's truly happening in your business.

Not Ideal For All Inventory

FIFO isn't a one-size-fits-all solution. Imagine a store selling trendy clothes. New styles come out fast, making older stock potentially obsolete. Assuming older items sell first, FIFO might leave you with unwanted garments.

Similarly, with expensive items like electronics, using older, lower purchase prices for COGS during deflation can significantly underestimate your profit. For these reasons, FIFO might be less ideal for businesses with fast-changing trends or significant price fluctuations.

FIFO Method Vs LIFO Method

Now that we've explored FIFO, let's compare it to its counterpart: LIFO, Last In, First Out. Understanding the differences between these two methods will help you choose the best fit for your business.

Cost Flow Assumption

While both FIFO and LIFO can be automated in accounting software, they differ in how they automate the cost flow assigned to inventory items.

• FIFO. Imagine a queue. New purchases with their associated costs are added to the back of the queue. When a sale occurs, the system automatically deducts the price of the first item (oldest purchase) in the queue for the COGS calculation. The remaining inventory reflects the costs of the items still in the "queue" (most recent purchases).
  
  
• LIFO. Think of a stack. New inventory purchases are added to the top of the stack with their costs. When a sale happens, the system deducts the price of the top item (newest purchase) for the COGS calculation. The remaining inventory reflects the costs of the items lower in the "stack" (older purchases).
  
  

Cost Of Goods Sold

FIFO and LIFO tell different stories about your inventory expenses.

• FIFO. Imagine a store selling TVs. During inflation, they sell older, cheaper TVs first. The COGS reflects these lower purchase prices, potentially boosting profits. However, during deflation, the COGS might be higher than the current market value, underestimating their true profit.
  
  
• LIFO. With LIFO, the store sells the most recently purchased, potentially more expensive TVs first. This means the COGS reflects these higher costs, potentially lowering profits during inflation. However, the COGS might be lower during deflation than the current market value, leading to higher profits.
  
  

Net Income

Imagine a company selling athletic shoes. Net income is profit after expenses, and COGS (cost of goods sold) is a big expense.

• FIFO (Inflation). They sell older, cheaper shoes first, leading to lower COGS and higher gross profit (revenue minus COGS). This translates to a higher net income. However, the opposite happens during deflation - COGS might be higher than the current value, lowering net income.
  
  
• LIFO (Inflation). They sell the newer, more expensive shoes first. This means a higher COGS and lower gross profit, resulting in a lower net income. However, during deflation, LIFO benefits because COGS is lower than its current value, boosting net income.
  
  

In short, FIFO tends toward higher net income during inflation. Meanwhile, LIFO offers a potentially more conservative view during inflationary periods.

Tax Implications

Tax time can be a different story with FIFO and LIFO. Imagine a business selling phones during inflation.

• FIFO. They show higher profits due to selling older, cheaper phones (lower COGS). This sounds great, but it means more taxable income and potentially a higher tax bill.
  
  
• LIFO. They use the cost of recently bought, more expensive phones for COGS, lowering reported profits. This might lead to a lower tax burden in the short term. But remember, it's a temporary benefit - selling the older, cheaper inventory later could mean higher taxes down the line.
  
  

Inventory Flow Alignment

FIFO and LIFO differ in how well they match your actual inventory flow. Imagine a store selling board games.

• FIFO. Aligns better with most businesses. You sell the older games you bought first, just like taking the front item off a shelf. This reflects the natural flow of inventory movement.
  
  
• LIFO. Doesn't necessarily reflect reality. You might sell newer games first, leaving older ones on the shelf. This can happen with fast-moving trends or changing customer preferences.
  
  

In essence, FIFO generally provides a more accurate picture of your current inventory overheads because it assumes you sell the older items first.

Financial Statement Representation

FIFO and LIFO paint different pictures on your financial statements. Imagine a company selling laptops during inflation.

• FIFO. Ending inventory reflects older, lower purchase prices. This can make your company look less profitable than it might be since current inventory expenses are higher. However, net income might be inflated due to the lower COGS.
  
  
• LIFO. Ending inventory reflects newer, higher purchase prices. This can make your company appear more profitable on the balance sheet due to a higher-valued inventory. However, net income might be lower because the COGS is higher.
  
  

So, FIFO shows potentially lower profitability with a more conservative inventory valuation, while LIFO might show higher profitability but with a potentially less accurate inventory value.

Choosing The Right Method

Choosing between FIFO and LIFO depends on your business and economic climate. Here's a quick guide:

• FIFO. A good fit for most businesses, especially those with stable or rising prices. It aligns with natural inventory flow and offers simplicity. It can also boost profits during inflation (tax implications apply).
  
  
• LIFO. Consider LIFO if you want a more conservative profit picture, particularly during inflation. It might also benefit businesses with fast-changing trends or significant price fluctuations, where FIFO might not reflect true inventory value. However, LIFO's tax benefits are temporary.
  
  

How Much Is The FIFO Inventory Costs?

The cost of FIFO inventory software can vary greatly depending on features, business size, and deployment options (cloud-based vs. on-premise). Free or low-cost options might exist for basic needs, but functionality often scales with price.

Expect to spend hundreds or even thousands of dollars annually on robust systems. Remember, the software cost is just one factor. Other factors include implementation fees, training costs, and potential ongoing maintenance expenses.

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Summary

Understanding the pros and cons of the FIFO inventory method can help you determine if it's right for you. It offers a practical and widely accepted solution.

However, during deflation or for businesses with rapidly changing inventory, FIFO might provide the most accurate picture. So, consider the information presented here and decide to optimize your inventory management and financial health.

Meanwhile, if you need a partner to ship your items, consider shipping them with Stallion! We offer the most competitive rates and affordable rates.

Aman Chopra

Aman looks after the content marketing department at Stallion Express. He is passionate about helping businesses grow by providing informative and up-to-date trends in the eCommerce industry. Outside the office, you can find him on the soccer field cheering on Real Madrid.