FIFO method: An explainer for small business owners

FIFO stands for ‘first in, first out’. This method is based on the idea that a business typically sells the first items it buys or produces before it sells its most recent inventory. Business owners who sell goods generally keep track of the inventory items they have in stock. They also track how much those items cost.

This article will explain what you need to know about the FIFO costing method, including its advantages and disadvantages, how to calculate it, and how it is different from other accounting methods.

What is the FIFO method?

The FIFO (first in, first out) method is an inventory costing method. In this process, the oldest inventory your business purchases is treated as the first inventory sold.

How to calculate FIFO

To calculate FIFO and the total cost of goods sold, multiply the cost of the item by how many items you’ve either bought or sold at that price.

Simple example

Say your business sells shirts. Your beginning inventory is zero. In January, you bought 10 shirts for $50. In February you sell six shirts. Your ending inventory is four. To get the cost of goods sold, you multiply the six shirts sold by $50.

• 6 x $50 = $300. Your COGS is $300.

The remaining cost of inventory is valued at 4 shirts x $50 = $200. Your remaining inventory value is $250.

More complex example

For many businesses, the FIFO inventory valuation is more complicated than that, as prices change over time.

Say you bought 10 shirts for $50 each in January. In February, you bought another 10 shirts but now they cost $60 each. In March, you sell 12 shirts.

Using the FIFO inventory method, you sell the oldest inventory first. That means the first 10 shirts you sold were those you bought in January, which cost you $50 each. The last two shirts sold (for a total of 12) were from February, which cost you $60 each.

To calculate the cost of goods sold, you take the number of shirts you sold at each price and multiply by that price. Then add the two resulting values.

• (10 shirts x $50) = $500
• (2 shirts x $60) = $120
• $500 + $120 = $620

After that sale, your ending inventory is the remaining eight shirts. All remaining shirts are valued at $60 each. To calculate the inventory value, multiply the number of shirts remaining by this value.

• 8 shirts x $60 = $480

The value of your ending inventory is $480.

When you report your financials, you report your COGS as $620. Your inventory value on the balance sheet is recorded as $480.

Why use the FIFO method?

The FIFO method has advantages for small business owners, especially those who sell items with expiration dates. FIFO accounting is the most commonly used inventory costing method for new businesses. It’s the default method for income tax.

• FIFO is also recognized under International Financial Reporting Standards (IFRS). This makes it a preferred option for small businesses operating in international markets.
• The FIFO method gives small business owners predictable profit margins. From there, they can make informed pricing decisions. This means you can automate much of your inventory tracking and financial calculations.

Other inventory accounting methods

Three other inventory accounting methods are sometimes used for calculating the cost of goods sold.

• Last in, first out (LIFO) accounts for the most recent inventory purchased being sold first while the oldest items are sold last. The ending inventory consists of the oldest stock. However, LIFO is not accepted under IFRS, making LIFO accounting less useful for some businesses than FIFO accounting.
• Weighted average cost method calculates the weighted average of all units available for sale during a period. To calculate the average cost, take the total cost of all stock purchased and divide it by the total units available for sale. This method is useful for businesses with minimal inventory cost changes.
• Specific identification method involves tracking and pricing each item of inventory individually. Because it involves more administration, it’s most useful for unique or high-value items, such as those sold at art galleries.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.