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

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.
 

 

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This method minimizes the risks of items becoming outdated, spoiled, or obsolete, thus ensuring better quality control and more efficient inventory turnover.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.

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.

 

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.
 

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.
 

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.
 

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.
 

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

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.

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

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.

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

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:

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

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.

Suppose a company has the following inventory purchases and sales:

•  January: Purchased 100 units at $10/unit