The FIFO method: inventory management for small businesses

Published on Wednesday 11 June 2025

• What is the FIFO method?
• Why is the FIFO method important?
• FIFO vs LIFO
• How to calculate FIFO
• Other inventory accounting methods
• FAQs on FIFO method

Key takeaways

• FIFO (First In, First Out) is an inventory accounting method that accounts for selling the oldest inventory items before the newer ones, even if that does not match the order of the items sold.
• Small businesses use this method because it's simple, aligns with natural inventory flow, and is accepted under international accounting standards. It also helps small businesses manage inventory, price products more accurately, and better prepare for tax season.
• During periods of inflation, FIFO can lead to higher profits but could also cause higher taxes compared with other methods like LIFO (last in first out).

What is the FIFO method?

FIFO stands for first in, first out – it's an inventory accounting method that accounts for selling the oldest inventory first. You don't actually need to sell the oldest item first – but you report the inventory for accounting purposes as if you sold the oldest item first.

For instance, say you buy widgets for $10. A month later, you buy more widgets for $11. When you sell the widgets, you start by accounting for the sale of the $10 widgets until they're all gone, then you account for $11 widgets. Even if you sell some of the newer widgets before the older ones, you still do the accounting as if you sold the oldest items first.

FIFO is a useful method in retail, manufacturing, warehouse operations, or any other industry that tracks inventory.

Small businesses prefer it because it’s the most natural inventory flow and is reasonably easy to use. It's used by about two thirds of American companies and is the default option for income tax returns.

While the IRS doesn't require all small businesses to track their inventory levels, doing so is helpful to track your inventory for budgeting as well as knowing the value of any inventory you have on hand.

Why is the FIFO method important?

FIFO offers several practical and financial benefits that make it a popular choice for inventory management. Here’s why it matters:

Aligns with the natural flow of your inventory

It's especially useful if you deal with stock rotation based on expiration dates – for instance, grocery stores and restaurants need to sell the oldest food first so it doesn't spoil.

Values your inventory accurately at a point in time

When you account for selling the oldest inventory first, your FIFO valuation reflects the value of the items you bought initially – therefore reflecting whether the prices have gone up or down.

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're using FIFO, you calculate COGS based on items you've already bought, which makes it easier to predict how changing prices will affect your future margins.

Gives variable results depending on market conditions

When prices rise (thanks to inflation, say) the FIFO method values your inventory higher. This, in turn, decreases your COGS and increases your net profit, which in turn increases your tax bill. But if costs go down, FIFO reduces your current inventory valuation, increasing COGS and shrinking net profit, ultimately leading to a lower tax liability compared with other inventory accounting methods.

Supports international expansion

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

FIFO vs LIFO

LIFO stands for last in, first out – the opposite of FIFO. LIFO calculates the value of your inventory as if you sold the newest items first – again, 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. Say a grocery store buys milk from its suppliers for $1 per gallon and then the price goes up to $1.50. The store sells the oldest $1 milk first so that it doesn't spoil, but because the store uses LIFO, its bookkeeper accounts 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.

Businesses can choose to use LIFO instead of FIFO for their income tax returns, but they must attach an election form to their return and commit to using LIFO until they get permission from the IRS to switch back.

Learn more with this IRS resource on FIFO vs LIFO.

How to use the FIFO method

Using the FIFO method means tracking your inventory purchases and applying costs in the order items were bought. Here's how to put it into practice:

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, COGS, and reporting.

Here’s more info on COGS and how to calculate it.

Other inventory accounting methods

There are other inventory accounting options businesses can use.

• Weighted average cost method (WAVCO)

WAVCO calculates the weighted average of all units available for sale over a set period – this smooths out price fluctuations and is useful for businesses with small inventory costs that don’t change much.

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. Say 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 $1100. When you sell an item, you account for its value based on the average cost of your items. In this case, that's $1100/20 or $55 per item. If you buy more items at different prices, you adjust the weighted average accordingly.

• Specific identification method

This requires you to track and price each item of inventory individually. It’s heavy on admin, so it’s most useful for low volume, unique or high-value items like art

FAQs on the FIFO method

Why is the FIFO method popular?

FIFO is popular because it complies with the International Financial Reporting Standards (IFRS). Businesses around the world use it because it's the most intuitive inventory tracking system – it just makes sense to sell the oldest items first. FIFO doesn’t suit every business, though, so talk to your accountant to find the inventory accounting method that works for you.

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

In times of rising prices, FIFO leads to higher profits on paper – boosting your cash flow but also raising your tax bill since you’ll have higher profits. You’ll have to manage your cash reserves carefully to stay liquid.

How does the FIFO method affect my gross profit margins during periods of inflation or deflation?

If prices are rising, FIFO increases gross profits by accounting for the sale of older, cheaper inventory first. And as prices fall FIFO decreases gross profits by accounting for the sale of older, higher-cost inventory first.

What challenges will I face using FIFO in a high-turnover or perishable goods industry?

If you use FIFO and you’re in a high-turnover industry or sell lots of perishable products, you’ll need to track your stock closely to prevent waste or spoilage. Organization can also be challenging – if you don’t rotate your stock properly, employees may sell or use newer items first,increasing the risk of spoilage.

High-turnover businesses need inventory management systems like Xero that track the age and location of inventory items in real time.

Simplify your inventory accounting with Xero

You don't have to do this by hand or even with a calculator – use Xero to automate inventory tracking and apply FIFO consistently across your products

Xero has many ways to help you track and manage your inventory.