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First In First Out: What Is FIFO And How It Works?

Time: Jan 26,2024 Author: SFC Source: www.sendfromchina.com

Managing inventory costs is crucial, particularly when facing supplier price increases and inflation. Accurately tracking inventory value over time is vital, regardless of the product.

The FIFO (First In, First Out) method is an effective approach in this context. It assumes that the oldest inventory is sold first, providing a realistic valuation of the remaining stock. FIFO involves recording inventory purchases chronologically and calculating the cost of goods sold based on the oldest items. This method helps maintain accurate financial records, especially for products with frequent price changes.

Now dive into this blog and you will learn what FIFO is and how it works.
 
what-is-fifo
 

1. What Is FIFO

In inventory management, FIFO, which stands for "First In, First Out," plays a crucial role, especially for items that have a shelf life, such as food, medications, or any perishable goods. Here, FIFO ensures that the oldest stock (those items that were added to the inventory first) is sold or used before newer stock.

This method minimizes the risks of items becoming outdated, spoiled, or obsolete, thus ensuring better quality control and more efficient inventory turnover. By adopting the FIFO approach, businesses can effectively manage their stock, reduce waste, and maintain consistency in product quality.


2. How the FIFO Method in Warehouse or Fulfillment Works

Implementing the FIFO method in a warehouse involves strategic organization and inventory tracking systems. Warehouses are typically set up in a way that facilitates this flow. For instance, new stock is placed behind or below the existing stock, ensuring that the older items remain accessible and are dispatched first. This can be achieved through various shelving systems, like gravity flow racks, where items move forward on inclined rails, or through careful manual organization. Moreover, advanced inventory management systems, including barcode scanners and warehouse management software, play a pivotal role in tracking the dates of stock arrival and ensuring the correct order of dispatch.

The effectiveness of the FIFO method in warehouse operations hinges on meticulous planning and adherence to processes. Staff training is vital to ensure everyone understands the importance of dispatching the oldest products first. It's not just about physically organizing stock; it's also about maintaining accurate records and understanding the dynamics of demand and supply. Regular audits and checks are essential to prevent errors that could disrupt the FIFO flow and lead to financial losses or diminished product quality.

 

3. What Are the Pros and Cons of FIFO

The FIFO method, widely used in inventory management and accounting, has several advantages and disadvantages:


Pros of FIFO 

Reduces Spoilage and Waste

FIFO is particularly beneficial for perishable goods like food or pharmaceuticals. By selling or using the oldest stock first, it minimizes the chances of items expiring or becoming obsolete.
 

Simplicity and Easy Implementation

The FIFO method is straightforward and intuitive, making it easy to implement and understand. This simplicity can lead to fewer errors in inventory management and accounting.
 

Accurate Representation of Inventory Cost

In times of inflation, FIFO provides a more accurate representation of the cost of inventory on hand. The cost of goods sold under FIFO reflects the cost of the older inventory, which is typically lower, thus showing a higher profit margin.
 

Aligns with Actual Flow of Goods

FIFO closely matches the actual physical flow of goods in most companies, especially in retail and manufacturing, leading to a more realistic view of inventory and sales processes.
 

Improved Customer Satisfaction

In industries like food service or retail, FIFO ensures customers receive the freshest products available, enhancing customer satisfaction.


Cons of FIFO

Potentially Misleading Profit Margins

During periods of rising prices, FIFO can inflate profit margins, as the cost of goods sold may be based on older, cheaper inventory. This inflated profit may not accurately reflect the current financial health of the business.

Tax Liability

Higher profits under FIFO could result in higher income taxes for the company in environments with rising costs or inflation.

Does Not Reflect Current Market Value

In times of falling prices, the cost of goods sold under FIFO may be higher than the current market cost, which can make a company less competitive in pricing its products.

Requires Rigorous Inventory Management

To effectively implement FIFO, a business must have a well-organized and meticulous approach to inventory management, which can be resource-intensive.

Less Useful for Non-Perishable Items

For non-perishable items or those with a long shelf life, the benefits of FIFO are less pronounced, as the risk of spoilage or obsolescence is lower.


4. How to Calculate FIFO

Calculating inventory using the FIFO (First In, First Out) method involves following a specific process to ensure that the cost of goods sold (COGS) and the value of ending inventory are accurately represented. Here's how to calculate FIFO:

4.1 Organize Inventory Purchases

Begin by listing out all the purchases of inventory in the order they were made, including the quantity and cost per unit for each batch. It's important to keep detailed records of each inventory purchase.

4.2 Determine the Quantity Sold

Identify the total quantity of items sold in the period you're calculating for. This information is typically obtained from sales records.

4.3 Calculate COGS Using FIFO

Start with the oldest inventory (first-in) and use its cost for the first set of items sold.

If the quantity sold exceeds the quantity of the oldest inventory, move to the next oldest batch of inventory to cover the remaining sales, and so on.

Continue this process until you've accounted for the total quantity sold.

Calculate the cost of goods sold by multiplying the number of units sold from each batch by the cost per unit for that batch and summing these amounts.

4.4 Calculate Ending Inventory

After accounting for the inventory that has been sold (using the steps above), the remaining inventory is your ending inventory.
The cost of the ending inventory is calculated using the costs of the most recent purchases (last-in).

Multiply the remaining quantities of each batch by their respective costs and sum these amounts to get the total cost of the ending inventory.


Example

Suppose a company has the following inventory purchases and sales:

•  January: Purchased 100 units at $10/unit
•  February: Purchased 150 units at $12/unit
•  March: Sold 200 units

Step 1: Organize Inventory Purchases

•  January: 100 units @ $10/unit
•  February: 150 units @ $12/unit

Step 2: Determine Quantity Sold

•  Total units sold: 200 units

Step 3: Calculate COGS

•  Sell 100 units from January stock: 100 units x $10/unit = $1,000
•  Sell 100 units from February stock: 100 units x $12/unit = $1,200
•  Total COGS: $1,000 (January) + $1,200 (February) = $2,200

Step 4: Calculate Ending Inventory

•  Remaining inventory from February: 50 units x $12/unit = $600

So, the COGS is $2,200 and the ending inventory value is $600 using the FIFO method.


5. FIFO vs LIFO

FIFO (First In, First Out) and LIFO (Last In, First Out) are two different methods used for inventory management and accounting purposes. Each method has a distinct approach to how inventory costs are accounted for and can significantly affect a company's financial statements. Here are the key differences between FIFO and LIFO:
 

5.1 Inventory Valuation

FIFO: Under FIFO, it's assumed that the first items added to the inventory (oldest stock) are sold first. Therefore, the ending inventory is made up of the most recently acquired items, which can reflect current market prices more closely, especially in times of inflation.

LIFO: LIFO assumes that the most recently acquired items (newest stock) are sold first. This means the ending inventory consists of the oldest items, which may not reflect current market values if there has been significant price fluctuation.


5.2 Cost of Goods Sold (COGS)

FIFO: The COGS under FIFO reflects the cost of the oldest inventory, which could be lower in times of rising prices, leading to a higher reported profit.

LIFO: The COGS under LIFO reflects the cost of the most recent purchases, which could be higher in times of rising prices, leading to a lower reported profit.
 

5.3 Impact on Financial Statements During Inflation

FIFO: In a period of rising prices, FIFO typically reports higher profits (since older, cheaper inventory is sold first), a higher ending inventory value, and potentially higher taxes due to increased profits.

LIFO: In contrast, LIFO typically shows lower profits during inflation (as the cost of goods sold is based on the higher costs of more recent inventory), lower ending inventory value, and potentially lower taxes due to reduced profits.


5.4 Tax Implications

FIFO: FIFO can lead to higher taxable income in times of inflation since the COGS is lower.

LIFO: LIFO can result in lower taxable income in times of inflation because the COGS is based on more recent, higher costs.


5.5 Inventory Management

FIFO: FIFO is often more aligned with the actual physical flow of goods, especially in businesses dealing with perishable goods, and is generally more intuitive for inventory management.

LIFO: LIFO does not typically represent the physical flow of inventory and is often used for its tax advantages or to better match current costs with current revenues.

 

5.6 Global Acceptance

FIFO: FIFO is widely accepted and used globally. It is compliant with International Financial Reporting Standards (IFRS).

LIFO: LIFO is primarily used in the United States and is not allowed under IFRS. Its acceptance and applicability are more limited internationally.



6. FAQs


1. How does FIFO impact financial statements?

FIFO can affect the reported profit margins, as it assumes the oldest, and often cheapest, inventory is sold first.

2. Is FIFO suitable for all types of inventory?

While FIFO is versatile, it's especially beneficial for perishable or trend-sensitive goods, less so for non-perishable items.

3. Can FIFO be used in all accounting systems worldwide?

FIFO is widely accepted, but its application may vary depending on the accounting standards and regulations of each country.

4. How does FIFO benefit consumers?

In retail, FIFO helps ensure consumers receive fresher products, as older stock is sold first.

5. What's the primary challenge of implementing FIFO in data structures?

In computer systems, the main challenge is ensuring efficient queue management to prevent bottlenecks.
 
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