FIFO method: How first in, first out simplifies inventory for small businesses

Published Wednesday 26 November 2025

Table of contents

• What is the FIFO method?
• Why is the FIFO method important?
• FIFO vs LIFO
• How to use the FIFO method
• Other inventory accounting methods
• Simplify your inventory accounting with Xero
• FAQs on the FIFO method

Key takeaways

• Implement FIFO by tracking each inventory purchase with its cost and date, then calculate your cost of goods sold using the oldest inventory prices first when making sales.

• Recognize that FIFO increases your reported profits during inflation by using older, cheaper costs for goods sold, which can improve cash flow but may result in higher tax payments.

• Apply FIFO if you sell perishable goods or want a straightforward inventory method that matches natural business operations and complies with international accounting standards.

• Automate your FIFO calculations using inventory management software connected to your point-of-sale system to eliminate manual tracking and ensure accurate cost accounting.

What is the FIFO method?

FIFO (First In, First Out) is an inventory accounting method that values your cost of goods sold based on the oldest inventory purchases first, regardless of which items you physically sell.

Here's how FIFO works in practice:

• Purchase tracking: Record inventory with dates and costs (widgets at $10 in January, $11 in February)
• Sales accounting: When you sell items, calculate costs using the oldest inventory first ($10 widgets before $11 widgets)
• Physical vs. accounting flow: You can physically sell newer items while accounting for older costs

FIFO is useful in retail, manufacturing, warehousing, and any industry that tracks inventory.

Small businesses prefer FIFO because it matches the natural flow of inventory and is easy to use. About two-thirds of American companies use it, and it’s the default option for income tax returns.

The IRS doesn’t require every small business to track inventory levels. But tracking your inventory helps you budget and know the value of what you have on hand.

Why is the FIFO method important?

FIFO helps you manage cash flow, align with natural inventory rotation, and understand your tax obligations during inflation. Here’s why it matters for your business:

Natural inventory flow

Natural inventory flow: FIFO matches how most businesses naturally rotate stock, especially for perishable goods like food that must be sold before expiration dates.

Accurate inventory valuation

FIFO values remaining inventory at current market prices since you account for selling older, cheaper items first during inflation.

Make it easier to predict profit margins

When you sell inventory, you report the cost of goods sold (COGS) – what you paid for the inventory – as an expense. If you use FIFO, you calculate COGS based on items you’ve already bought. This makes it easier to predict how changing prices will affect your future margins.

Gives variable results depending on market conditions

When prices rise due to inflation, FIFO values your inventory higher. This decreases your cost of goods sold and increases your net profit, which can increase your tax bill. If costs go down, FIFO lowers your current inventory value and increases your cost of goods sold. This can reduce your net profit and lower your tax liability compared with other inventory methods.

Supports international expansion

Because FIFO complies with International Financial Reporting Standards (IFRS), it’s easier to keep your financial reporting consistent as your business grows into new markets – so you don’t have to change your reporting if you expand overseas.

FIFO vs LIFO

LIFO stands for last in, first out – the opposite of FIFO. LIFO calculates your inventory value as if you sold the newest items first – even though you don’t actually need to sell the newest items first.

Here’s an example of when it makes sense to sell older items first for effective inventory management, even if you use the LIFO system. Imagine your grocery store buys milk for $1 per gallon, then the price rises to $1.50. You sell the oldest $1 milk first so it doesn’t spoil. But if you use LIFO, you account for the sale as if the $1.50 milk (bought last) was sold first.

During inflation, LIFO keeps the least expensive items on the books, meaning your inventory is worth less on your balance sheet. That also means that your business accounts for selling the most expensive items first – a move that increases your COGS, decreases net profits, and leads to lower income taxes. FIFO does the opposite, as described above.

You can choose to use LIFO instead of FIFO for your income tax returns. You must file a form with your return to elect to use LIFO and commit to that method until you get permission from the IRS to switch back.

You can find more details in this IRS guide comparing FIFO and LIFO.

How to use the FIFO method

Implementing FIFO means tracking your inventory costs chronologically to calculate accurate cost of goods sold. Follow these steps to apply FIFO to your business:

1. Track each inventory purchase with cost and date

Record every batch of inventory with its purchase price and date. For example:

• January: 30 units at $10 each
• February: 40 units at $10.50 each
• March: 30 units at $11 each

2. Apply the cost of the oldest items first when selling

When you sell items, calculate your Cost of Goods Sold (COGS) using the oldest inventory prices first.

• If you sell 30 items in March, use the January batch: 30 × $10 = $300
• For a second sale of 40 items, use the February batch: 40 × $10.50 = $420

3. Record your COGS in your accounts

For each sale:

• Debit your COGS account by the total cost of the items sold (e.g., $300)
• Credit your inventory account by the same amount to reduce your stock value

4. Use the FIFO method in your COGS formula

You can also use this formula to calculate COGS:

Starting inventory + purchases – ending inventory = COGS

Using the example above:

• Starting inventory = $0
• Inventory purchases = $1050
• Ending inventory = $330
• COGS = $0 + $1050 – $330 = $720

Make sure your ending inventory reflects the value of your most recent purchases, since FIFO assumes the oldest items are sold first.

5. Automate FIFO tracking with inventory software

Manual tracking can get complex, so use inventory management software to automate FIFO calculations. Just log your purchases and connect your point-of-sale (POS) system – the software will handle costing, cost of goods sold, and reporting.

More info on COGS and how to calculate it.

Other inventory accounting methods

Small businesses can choose from several inventory accounting methods beyond FIFO:

Weighted average cost method: Calculates the average cost of all inventory units, smoothing out price changes. This method works best for businesses with minimal price changes.

To calculate the average cost, take the total cost of all stock you've bought and divide it by the total units you have for sale.

Here’s a quick example. You buy 10 items for $50 each. Prices go up, and you buy 10 more items for $60 each. Your total inventory is now worth $1,100. When you sell an item, you use the average cost of your items. In this case, that’s $1,100 divided by 20, or $55 per item. If you buy more items at different prices, you adjust the weighted average.

Specific identification method: This method tracks each inventory item individually by serial number or unique identifier. It’s used for high-value or unique items like artwork or vehicles.

Simplify your inventory accounting with Xero

You can automate FIFO calculations and inventory tracking with Xero, so you don’t have to do manual work. This helps you keep accurate cost accounting across all your products.

With Xero’s inventory features, you can implement FIFO without spreadsheets or complex calculations. Learn more about your options for tracking and managing inventory in Xero.

FAQs on the FIFO method

Here are common questions and answers about the FIFO method for small businesses.

What is the difference between FIFO, LIFO, and FEFO?

FIFO (First-In, First-Out) assumes the first items purchased are the first ones sold. LIFO (Last-In, First-Out) assumes the last items purchased are sold first. First expired, first out (FEFO) prioritizes selling items with the earliest expiration dates, which is critical for businesses dealing with perishable goods.

Is the FIFO method allowed for tax purposes in the US?

Yes, FIFO is a widely accepted inventory valuation method by the Internal Revenue Service (IRS) and aligns with Generally Accepted Accounting Principles (GAAP). It's the most common method used by US businesses for its simplicity and logical flow.

When should a small business choose FIFO over other methods?

You should consider FIFO if you sell perishable goods or products with a limited shelf life. FIFO matches the natural flow of inventory. It’s also a good choice if you want a straightforward, compliant method that gives you an accurate picture of your current inventory value and profit, especially when prices are stable or falling.

Why is the FIFO method popular?

FIFO is popular because it's intuitive, internationally accepted, and matches natural business operations.

Key reasons businesses choose FIFO:

• Global compliance: Meets International Financial Reporting Standards (IFRS)
• Natural logic: Selling oldest items first makes operational sense
• Widespread adoption: Used by about two-thirds of US companies

Talk to your accountant to see if FIFO is right for your business.

How does the FIFO method affect the way a business manages its cash flow and working capital?

FIFO increases reported profits during inflation, which can improve your cash flow. You may need to plan for higher tax payments.

During rising prices, FIFO:

• Boosts cash flow: Higher profits improve your financial position
• Increases taxes: Higher reported income means larger tax bills
• Requires planning: Set aside cash reserves for tax payments