FIFO

For any business owner, inventory management is one of the most crucial tasks responsible for a business’s cash flow. Therefore, understanding the different methods available for financial resource flow is critical. Inventory management techniques help business owners calculate the cost of goods sold, profit, and the value of ending inventory. 

Currently, many techniques and methods are available that companies can explore for their business. Depending upon the business needs, they can adopt FIFO, LIFO, and average cost inventory. This article mainly focuses on the FIFO technique, what it means, and how you can successfully implement it in your business. 

What Is The FIFO Method?

First In, First Out, also known as FIFO, is one of the most widely used methods for inventory management. To put it simply, the first goods purchased are the first ones to be sold. The remaining inventory consists of items purchased last. 

Various companies across different industries prefer this method over others. t not only helps to provide a clear picture of the actual flow of goods but also reduces the risk of inventory obsolescence. 

An example of industries that can benefit from the FIFO method might include companies that deal with perishable goods like food and flowers. For the said companies, the longer their items are left in the inventory, the higher the chances of them getting damaged. Since the FIFO technique allows owners to ship out their oldest products first, followed by the recent ones, it helps them reduce waste and, ultimately, loss. 

Implementing the FIFO method can benefit businesses, especially in rising prices and inflationary markets. This is because FIFO assigns the oldest costs to the cost of goods sold. The older prices will automatically be lower than the recent inventory purchase cost, ultimately leading to a higher net income for the company. 

How The FIFO Inventory Valuation Method Works

As stated earlier, FIFO is one of the most commonly used methods of inventory management by various companies worldwide. Many companies are in the habit of buying items at different prices throughout the year. They might sell most of their products, but chances are that some will be left by the end of the year or the month. So what happens to these said products?  

The FIFO method assigns these items to the cost of the most recent purchases. Under this method, businesses can cover the item left in inventory at the end of the month or the year under the cost of the most recent goods sold. 

FIFO in Cost of Goods Sold Accounting

Under the FIFO method, the first goods that companies purchase are also the first ones to be sold out. The said company then reports the older costs in its income statement, and the cost of the recently purchased items gets reflected on the current inventory. In this, companies can calculate their cost of goods sold, without any fluctuations in the inventory costs. 

There are multiple reasons why FIFO works so well and is one of the most trusted methods currently available in the market. The two primary ones among them include
 

• Products are shipped out to customers on a first-come, first-served basis. This means assets acquired first are disposed of first.  This ensures a continuous flow of materials, reducing waste and increasing profit. Furthermore, when the inventory assets are listed on the balance sheet at the end of a period, it highlights the most recent purchase costs. 

• With the help of FIFO, business owners can also hold off raising sale prices. This comes in handy, especially at a time when the cost of products is steadily increasing. The FIFO method enables companies to delay raising the sale prices until the lower-cost items are fully replenished. Once they have been shipped, they can focus on the recent batch of products bought at a slightly higher price and raise the sales prices accordingly. 

The FIFO Method in Warehousing and Fulfillment

One of the most interesting aspects of the FIFO method is that businesses can use this inventory valuation method both in warehouse management as well as in accounting. So how does FIFO warehousing exactly work?

FIFO warehousing deals with how the goods are moved out of the warehouse. The first batch of goods that gets loaded in the warehouse is prioritized to get shipped out as well. 

The FIFO technique is ideal for perishable goods with a fixed expiry date. This might include foods, medicine, and even technological products, like home appliances, computers etc. It is one of the most common methods used by various companies to store products that can go out of style or become obsolete if kept in storage for a long time. 

The ultimate goal of this technique is to generate an excellent stock turnover in the warehouse. It gives importance to the output of products that have been stored for a long time to prevent them from getting damaged or spoiled. Companies use the FIFO technique in warehouses and supermarkets, and other consumer outlets to manage products. This helps eliminate any possibility of total or partial loss of value of products stored, or their future devaluation in the market, because of their manufacture date. 

Examples of calculating inventory using FIFO

While calculating inventory using FIFO, you must first find out the cost of your initial inventory. Use that number to multiply the cost of goods sold by the amount of inventory sold. 

To help you better understand, below are a few examples of how FIFO is used to calculate the inventory. 

Let’s say, Tara visits a pet supply store and buys 80 boxes of vegan cat treats for $3 each. After a few months, she again goes to the same store, and this time she purchases 150 boxes of vegan cat treats for a slightly higher price of $4 each. Tara now owns a total of 230 boxes of cat treats in stock, out of which only 100 have been sold out to potential customers. 

In the balance sheet, the total cost of goods sold would turn out to be $320. 

This is because, while calculating the total cost of goods sold using the FIFO technique, the formula is as follows:

Cost Of Goods Sold (COGS)= (Number of Original Units x Their Value) + (Remaining Items from the Second purchase x their value)

In order to calculate the value of the remaining inventory, you need to use the below-mentioned formula.

Ending Inventory Value = Remaining Units x Their Value. 

Here’s another example of calculating inventory value using FIFO.

Let’s say a stationary company produced two batches of stationery products. The first batch contains 10 items, priced at $30 each. So the total cost for the first batch is $300. The second batch contains 50 items, priced at $40 each, and the total cost turned out to be $2000. However, out of these 60 items owned by the company, it could only sell 20 items to the customers. So, according to the FIFO method, the first items to be bought are the first items to be sold out. That means that the said company was able to sell 100% of the first batch and 10% of the second batch. 

So, if you want to find out the total cost of the products sold, you need to apply the below-mentioned formula. 

Cost Of Goods Sold (COGS)= (Number of Original Units x Their Value) + (Remaining Items from the Second purchase x their value)

This means that the total cost of goods sold by the stationary company is $700, and the total inventory ending value is $1600. 

The “Bullwhip Effect” and FIFO Cost Flow Assumption

Coined by Procter and Gamble, the ‘bullwhip effect’ is a phenomenon whereby small fluctuations in demand at the retailer level can result in larger fluctuations at the manufacturer, distributor, and raw materials supplier levels. 

To put it simply, any change in the link along the supply chain can profoundly affect the rest of the supply chain. In supply chain management, every person has a role to play. Be it the distributor, the manufacturer, or even the retailer, each has its perspective of demand and subsequently tries to control the entire chain accordingly. Some might order too much, while others might order too little. All these forecasting inaccuracies can directly impact the whole supply chain, ultimately determining a company’s subsequent profit or loss. 

Here is a simple example to help you understand this concept better. 

Let’s say that a food company keeps 100 six-packs of one snack brand in stock. On average, the company can sell only 20 six-packs of the particular brand and accordingly asks for a refill from the distributor. However, on one particular day, the company was able to sell almost 80 six-packs of the particular item and automatically assumed that they would be able to keep up with this increased demand soon. So to meet this higher forecasted demand, the company asks for 100 six-packets of the particular item from the distributor. 

To ensure that the company does not run out of products, the distributor then adds another 100 six-packs to the number ordered by the company. The number subsequently starts to increase unless it reaches the manufacturers. This flow of increased demand being amplified along the various levels in the supply management chain is called the bullwhip effect. 

Although the stated example only highlights a scenario with a higher demand at the customer level.  It is important to remember that this phenomenon holds in cases of lowered demand at the customer level as well, which ultimately leads to a shortage of items when the calculations or predictions are inaccurate. 

Causes Of The Bullwhip Effect

The bullwhip effect can occur due to several reasons. It can be because of insufficient information, inaccurate decisions, and even in stable markets when the demand is relatively constant. Mentioned below are some of the most common reasons that lead to the bullwhip effect. 

• Lack of communication between each link
• Overestimation or underestimation of demand expectations; ordering too many or ordering too few. 
• Cost variations can lead to a significant change in customer buying behavior. 
• Over-dependence on historical demands to understand future demands. 

Ways To Prevent The Bullwhip Effect

In order to prevent or reduce the bullwhip effect, you need to maintain proper communication at every level of the supply chain and generate better information and forecasting methods. Here are some of the ways to counteract the bullwhip effect. 

• Stay up-to-date with the stock of not only your own inventory but also your supplier’s inventory 

Many companies often do not know what their supplier’s inventory looks like. In such scenarios, when the bullwhip effect starts, there are chances that your suppliers can have tons of items piled up in their inventory or could even be dropping their inventory level, seeing a huge demand for bigger orders. 

• Avoid delays, and find ways to speed up delivery

You can reduce the bullwhip effect by half by reducing the delivery time. This ensures that the products are moved faster, and the problem of them getting piled up in the inventory gets automatically eliminated. One way to do this can be by loading multiple types of items in one truck or taking the help of third-party logistics. 

• Use technology to avoid errors

In this technology-driven world, several softwares and portals are available designed specifically to save time and avoid human error. Harness that power to boost profit for your business. It might include supplier portals to ensure a smooth flow of communication or supply chain automation software and inventory management technologies.

As stated earlier, the FIFO method assumes you will sell all the older goods and items before moving on to the next. So what happens when a company experiences the bullwhip effect? This cost flow assumption gets extremely complicated since the older goods become unsalable or obsolete because of the changes in customer preferences. 

In order to prevent all these from happening, you can refer to the above-mentioned ways to reduce this disruptive phenomenon. 

Why Use FIFO vs Other Methods?

FIFO is not the only option available in the market to manage your inventory. Infact, there are various methods that a business can opt to determine the cost of goods sold in the company. Below is a list of the same, containing detailed information about each method so you can determine which one will work best for your business. 

LIFO

Contrary to the FIFO technique, LIFO, also known as Last In First Out, is yet another inventory management method used by various companies worldwide. Under this technique, the last goods to get loaded into the inventory or the recently purchased items are the first ones to be sold out. This means that the oldest items remain in the ending inventory. 

However, companies that deal with non-perishable products usually use the LIFO technique. It can be beneficial, especially when the price of goods increases. This method helps companies increase the overall cost of goods sold, leaving the cheaper and older products as inventory. 

Average Cost Inventory

Under this method, the company assigns the same cost to each item in the inventory. It is also known as the weighted average technique. To calculate the average cost, you need to determine the cost of available goods and then divide that number by the total number of items from the beginning inventory and purchases. This is one of the three most popular inventory management techniques, the other two being FIFO and LIFO. 

The average cost inventory technique is usually applied when assigning a specific price to every item in the inventory becomes difficult. This can occur when companies deal with products with similar characteristics or properties. To calculate the weighted average cost, you need to find out the total cost of items in the inventory and then divide that number by the total number of units. 

Both these above-stated methods have their own sets of pros and cons. As a business owner, you must first identify your business’s needs and demands and implement these techniques accordingly. 

PROs Of FIFO

Apart from being the most widely used method across various companies, FIFO also boasts of being the most accurate method that provides business owners with a clear and transparent view of inventory costs. Here is a list of some of the few benefits that you can get using the FIFO method. 

Lower waste due to obsolescence 

Businesses use the FIFO technique to minimize losses that obsolete or damaged products can cause. Since the oldest products in the inventory are the first ones to get sold out, it ensures a smooth and more intuitive flow of goods. 

Quality control improvements

FIFO also helps companies provide an improved experience to customers. When the oldest products are shipped out from the warehouse, it ensures that your customers always receive consistent products and not obsolete items that were not regulated properly while still in the warehouse. 

Warranty issuance and control

As stated earlier, FIFO is extremely beneficial for products with a specific expiration date or a warranty period. Shipping out the oldest products ensures that the warranty will still be good, even after the customers receive the products. Furthermore, this also helps companies to save money on the quality control of products that are partially close to warranty expiration dates. 

Availability of most recent product iterations

The FIFO technique enables you to deliver the most recent and desirable versions of the products to your customers. This enriches the customer buying experience and helps companies to cut down on the risk of shipping old products to customers. This especially applies to products frequently iterated upon, including electronic appliances or household goods, among many others. 

Cons Of FIFO

While there are several reasons why companies should implement the FIFO method in their business, there are many downsides to this technique as well. Mentioned below is a list of the same. 

Requires better systems for compliance

In order for FIFO to truly work, you need to constantly enforce it with some form of automation and management system. This especially gets difficult when warehouses,which deal with huge loads of goods, are constantly getting loaded and shipped out, combined with the layout and accessibility of the stocks. In order to ensure a fully efficient process, you might need to use some system upgrades to get the best results.

Can be difficult to track at scale

Yet, another common problem most companies face while using FIFO is keeping track of the FIFO efforts at scale. This holds for large warehouses with multiple items in stock at different locations or huge turnovers on your stock. Therefore, the larger your inventory, the harder it is to maintain the necessary tracking. 

To curb this problem and help boost operations, you will require the help of good and upgraded systems. However, FIFO can be easily implemented in small environments even with fewer staff members. 

System rigidity can result in inflexibility in some situations 

The FIFO capabilities implemented in the warehouse management system can turn out to be too rigid for companies dealing with certain items like food, beverages and pharmaceuticals. This is because they have a fixed expiration date, after which they become outdated. Therefore, your management system needs to be flexible enough to consider all these items to prevent loss and waste. 

May require redevelopment of physical space 

Another major problem that comes with FIFO is the space in your warehouse. After implementing FIFO, you might have to rearrange your whole inventory to make new space for rotation. Furthermore, there are also chances that the current set-up of your warehouse might make it impossible to rotate new deliveries to the back-of-stock locations. All these changes are extensive and can consume much more time than preferred. 

Should Your Business Utilize FIFO?

Keeping track of your business’s inventory and implementing the best inventory valuation method is extremely important since it helps you maximize your profit and minimizes all the tax burden from the sale. That is where FIFO comes into play. 

First In, First Out control methods can revolutionize your everyday operations and drive better performance from your warehouse. Many companies prefer it for their business because of its range of benefits. 

What’s more, companies using FIFO have reported higher profit margins than those using other methods, especially during periods of inflation. It is indeed one of the most effective ways to keep your stocks fresh, process your inventory and prevent any items in your inventory from getting obsolete. 

When is the FIFO Method Used?

Certain industries can benefit from using the FIFO technique. Mentioned below is a list that highlights the same. 

Small businesses

As stated earlier, small businesses can reap huge benefits by implementing the FIFO technique in their management processes. It is much simpler to use and can be done even with a small number of staff members. Even if a business does not have a large amount of inventory, FIFO can effectively meet all your demands and outweigh the savings, which might not be possible with other alternative methods like LIFO.

Perishable goods

The FIFO method clearly states that the first ones to be loaded into the inventory are also the first ones to be sold out. Many companies deal with perishable products like food, beverages, pharmaceuticals, and even technological equipment like computers. Some of them have an expiration date, and if they are kept on the inventory shelves for too long, they will ultimately get damaged and result in loss. 

FIFO helps to minimize this problem by shipping out the oldest products so that they do not spend too much time in the inventory. What’s more, FIFO also ensures that these companies’ inventory and balance sheet match what it does with their stocks by putting the older products first so that they sell quickly. 

Goods for export

According to the International Financial Reporting Standards (IRSF), LIFO is banned in certain countries except for the USA. Companies that deal with international businesses or report their taxes to foreign countries use the FIFO method. FIFO is one of the most commonly used methods worldwide, making it convenient to most companies to follow this technique to avoid complexities. 

Companies that want to match their balance sheet accurately with the value of their inventory rely heavily on the FIFO method.  It enables them to keep newer and higher value items on their balance sheet, thus making the company’s asset base appear larger. However, like all other techniques, FIFO too has certain downsides that can be detrimental to certain companies if not implemented correctly. For example, you might have to pay equally higher tax amounts while reporting higher profits on the less expensive, older inventory items. 

However, it is not mandatory to continue using one specific method for years. As a business owner, you have the liberty to switch between different methods and choose the one that bears the maximum profit for your company. While doing so, you can seek the guidance of a CPA, to help simplify this somewhat complex process. 

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