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

Published Wednesday 27 May 2026

Table of contents

• What is the FIFO method?
• Why is the FIFO method important?
• Advantages and disadvantages of FIFO
• FIFO vs LIFO
• How to use the FIFO method
• When to use FIFO (and when not to)
• Other inventory accounting methods
• Real-world FIFO examples by industry
• Simplify your inventory accounting with Xero
• FAQs on the FIFO method

Key takeaways

• FIFO (First In, First Out) is an inventory accounting method that assigns the cost of your oldest inventory to the cost of goods sold first, giving you a more accurate picture of current inventory value.
• About two-thirds of American companies use FIFO because it aligns with the natural flow of goods and is accepted under both GAAP and IFRS standards.
• During periods of rising prices, FIFO typically results in higher reported profits and a higher inventory valuation on your balance sheet, which can affect your tax liability.
• Automating FIFO tracking with accounting software saves time, reduces errors, and keeps your financial records accurate as your business grows.

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. It assumes the items you bought or produced earliest are the ones you sell first.

In practice, FIFO means you assign the cost of your earliest purchased inventory to each sale before moving on to newer, potentially more expensive stock. FIFO is purely a cost assignment method for your accounting records. The physical order in which items leave your warehouse is a separate operational decision.

Say you run a small business selling widgets. You buy 100 widgets in January at $10 each, 100 in February at $10.50 each, and 100 in March at $11 each. If a customer orders 150 widgets, FIFO assigns the cost of the first 100 at $10 (January's price) and the remaining 50 at $10.50 (February's price). Your cost of goods sold for that order is $1,525.

FIFO is the most widely used inventory costing method in the United States. About two-thirds of American companies use it, and it's the default option for income tax returns according to the IRS.

Why is the FIFO method important?

FIFO matters because it directly affects your reported profits, tax obligations, and the accuracy of your financial statements. Choosing the right inventory method shapes how your business looks on paper and how much you owe at tax time.

• Cash flow and profit margins. When prices are rising, FIFO assigns lower (older) costs to the goods you sell. This means your cost of goods sold is lower, which increases your gross profit. Higher reported profits can make your business more attractive to lenders and investors, but they also mean a higher tax bill.
• Natural inventory rotation. FIFO mirrors how most businesses actually move their products. Grocery stores sell older milk before newer milk. Retailers put last season's stock on the floor before this season's arrivals.
• Tax implications. Because FIFO often results in higher taxable income during inflationary periods, you may pay more in taxes compared to other methods like Last In, First Out (LIFO).
• Accurate balance sheet. FIFO leaves your most recently purchased (and usually most expensive) inventory on your balance sheet. This gives a more realistic picture of what your remaining stock is actually worth at current market prices.
• International compliance. FIFO is accepted under both US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). If you do business internationally or plan to expand, FIFO keeps your books compliant across borders.

Advantages and disadvantages of FIFO

Understanding the strengths and limitations of FIFO helps you decide whether it's the right fit for your business.

Advantages of FIFO

FIFO offers several practical benefits for small businesses managing inventory.

• Reduces waste and spoilage risk. Selling older inventory first helps you avoid expired or obsolete stock sitting on shelves.
• More accurate balance sheet. Remaining inventory is valued at recent purchase prices, giving a realistic snapshot of your assets.
• Trusted by most businesses. About two-thirds of American companies use FIFO, making it the most common inventory method in the US.
• Simple IRS process. The IRS treats FIFO as the default inventory method, so you can start using it without filing additional paperwork.
• Easier to understand and apply. The logic behind FIFO is straightforward, which makes it simpler to implement and explain to stakeholders.

Disadvantages of FIFO

FIFO has some limitations to consider before choosing it as your inventory method.

• Higher taxes during inflation. When prices rise, FIFO reports higher profits because older, cheaper costs are matched against current revenue, which means a bigger tax bill.
• Can overstate profitability. The gap between older costs and current selling prices may inflate your margins on paper, even if your actual purchasing power hasn't improved.
• Performs differently when prices fall. If your inventory costs are falling, FIFO assigns higher (older) costs to sales, which can understate your profits.
• Better suited to commodity inventory. Businesses dealing in unique, high-value items like art or custom machinery may find specific identification more accurate.

FIFO vs LIFO

FIFO and LIFO (Last In, First Out) are opposite approaches to inventory costing. FIFO assigns the oldest costs to goods sold, while LIFO assigns the newest costs first. The method you choose can significantly impact your profits and taxes.

Think of it like a grocery store dairy aisle. With FIFO, the store sells the oldest milk first, pushing earlier cartons to the front. With LIFO, the store would sell the newest milk first, leaving older cartons to sit at the back. In reality, no grocery store operates this way, which is why FIFO is the more natural fit for most businesses.

The biggest practical difference comes down to taxes. During periods of rising prices, LIFO assigns higher (newer) costs to goods sold, which lowers your taxable income. FIFO does the opposite, reporting higher profits and a higher tax bill. LIFO also comes with trade-offs: your balance sheet shows older, lower-valued inventory, which can misrepresent your actual assets.

There are also compliance differences. FIFO is accepted under both GAAP and IFRS. LIFO is only allowed under GAAP and is banned under international standards. If you ever plan to operate or report internationally, LIFO could create complications.

If you choose LIFO, the IRS requires you to file Form 970 with your tax return for the first year you adopt it. FIFO is the default method for US tax returns.

How to use the FIFO method

Applying FIFO to your business involves a clear, repeatable process. Follow these five steps to track your inventory costs accurately.

1. Track every inventory purchase

Record the date, quantity, and unit cost of each inventory purchase as it happens. Keeping detailed purchase records is the foundation of accurate FIFO accounting. This data is what lets you assign costs to sales in the right order.

2. Apply the oldest costs to each sale

When you make a sale, assign the cost of your oldest available inventory first. Work through your purchase records chronologically until you've accounted for the full quantity sold. If a single sale spans more than one purchase batch, split the cost accordingly.

3. Record your cost of goods sold

Add up the costs you've assigned to each sale. This total is your cost of goods sold (COGS) for that transaction or period. Accurate COGS figures are essential for understanding your gross profit and filing your taxes correctly.

4. Use the COGS formula

Calculate your total COGS for an accounting period using this formula: starting inventory + purchases - ending inventory = COGS. For example, if you started the quarter with $5,000 in inventory, purchased $8,000 more, and had $4,000 left at the end, your COGS would be $9,000. Learn more about calculating cost of goods sold.

5. Automate with inventory software

Manually tracking FIFO gets complicated as your business grows. Inventory management software can automatically apply FIFO costing to every sale, keep your records up to date, and reduce the risk of errors.

When to use FIFO (and when not to)

FIFO is the best choice for most small businesses, though some situations call for a different method. The right method depends on the type of products you sell and how your costs change over time.

FIFO works well for:

• Perishable goods. If you sell food, beverages, or anything with an expiration date, FIFO reflects how you actually rotate stock.
• Retail businesses. Clothing, household goods, and seasonal products naturally follow a first-in, first-out flow.
• Manufacturing. Raw materials purchased earlier are typically used first in production, making FIFO a logical match.
• Businesses with rising costs. FIFO gives you a more accurate balance sheet when the cost of your inventory trends upward over time.

Consider an alternative to FIFO if you sell:

• Electronics and technology. Product costs often decrease over time as newer models replace older ones. FIFO could overstate your COGS in these cases.
• Luxury or unique items. One-of-a-kind products like fine art, custom furniture, or vintage goods are better tracked with specific identification.
• Businesses with highly fluctuating prices. If your inventory costs swing up and down unpredictably, weighted average cost may smooth out the volatility better than FIFO.

Other inventory accounting methods

FIFO is one of several ways to value your inventory. Understanding the basics of inventory accounting can help you decide which method works best. Depending on your business, one of these alternatives might be a better fit.

Weighted average cost

This method calculates the average cost of all units available for sale during a period and applies that single cost to every unit sold. It's simpler than tracking individual purchase batches and works well when your products are interchangeable and costs don't vary much.

Specific identification

Specific identification tracks the actual cost of each individual item in your inventory. It's the most precise method but only practical for businesses selling unique or high-value items like vehicles, jewelry, or real estate. For businesses with large volumes of identical products, specific identification becomes impractical.

FEFO (first expired, first out)

FEFO is a stock rotation practice rather than a formal accounting method. It's used alongside FIFO. It prioritizes selling items closest to their expiration date first. Pharmacies, food distributors, and cosmetics businesses often use FEFO to minimize waste and comply with safety regulations.

Real-world FIFO examples by industry

Seeing FIFO in action across different industries helps you understand how it applies to your own business. Here are four common scenarios.

Grocery store

A small grocery store buys 200 cartons of eggs in week one at $2.50 each and 200 more in week two at $2.75 each. When 250 cartons sell that month, FIFO assigns the first 200 at $2.50 and the next 50 at $2.75. The COGS for those 250 cartons is $637.50, and the remaining 150 cartons on the balance sheet are valued at the newer $2.75 price.

Retail clothing

A boutique orders 50 jackets in September at $40 each for the fall season, then another 50 in November at $45 each. When 60 jackets sell by December, FIFO costs the first 50 at $40 and the remaining 10 at $45. The COGS is $2,450, while the 40 unsold jackets are valued at $45 each on the balance sheet.

Manufacturing

A furniture maker buys lumber in two batches: 500 board feet in March at $3 per foot and 500 board feet in May at $3.50 per foot. When 700 board feet are used in production, FIFO assigns the first 500 at $3 and the remaining 200 at $3.50. The material cost for that production run is $2,200.

Pharmacy

A pharmacy receives 100 units of a medication in January at $8 each and 100 more in March at $8.50 each. When 120 units are dispensed, FIFO assigns the first 100 at $8 and the next 20 at $8.50. The COGS is $970, and the 80 remaining units are valued at $8.50 on the books.

Simplify your inventory accounting with Xero

Tracking inventory costs by hand takes time and leaves room for mistakes. As your business grows, staying on top of every purchase batch and sale gets harder.

Xero's accounting software helps you manage your inventory and cash flow in one place. You can track stock levels, monitor costs, and keep your financial records accurate without juggling spreadsheets. Try Xero for your business and get one month free.

FAQs on the FIFO method

Here are answers to some of the most common questions about FIFO inventory accounting.

What does FIFO stand for?

FIFO stands for First In, First Out. A common misconception is that FIFO dictates how you physically ship products, but it's strictly a cost assignment method for your accounting records.

Is FIFO required by the IRS?

FIFO applies to all business structures, from sole proprietors to corporations. Once you start using FIFO, switching to a different method requires IRS approval through Form 3115.

How does FIFO affect taxes?

FIFO can increase your taxable income during inflation, so it's worth setting aside cash reserves each quarter for your tax bill. Talk to your accountant about how FIFO affects your specific tax situation before committing to a method.

Can you switch from LIFO to FIFO?

Yes, you can switch from LIFO to FIFO. However, the change requires IRS approval by filing Form 3115, and you may need to make adjustments to your income for the year of the switch.

Is FIFO or LIFO better for small businesses?

If you're just getting started, FIFO is usually the simpler and safer choice since it requires no additional IRS filings. Once your business is established, review your method annually with your accountant to make sure it still fits your growth stage and tax strategy.