Guide to Understanding FIFO: First-In, First-Out

Ever wondered how businesses keep track of their inventory and ensure older stock gets sold first? That’s where FIFO, or First-In, First-Out, comes in. It’s a simple yet effective inventory management method that follows a straightforward rule—the first items you buy are the first ones you sell. This approach is widely used in retail, manufacturing, and even the food industry to prevent spoilage, maintain accurate financial records, and optimize profits. In this guide, we’ll break down how FIFO works, compare it to other inventory methods, and help you decide if it’s the right fit for your business.

What is the FIFO Method?

Understanding FIFO (First-In, First-Out) in Inventory Management

FIFO, or First-In, First-Out, is one of the most widely used inventory management methods. The concept is simple: the first products added to inventory are the first ones sold or used. This ensures that older stock moves out before newer stock, reducing the risk of spoilage, obsolescence, or inventory loss. 

FIFO is particularly important in industries dealing with perishable goods, such as food and pharmaceuticals, where selling older inventory first prevents waste and maintains product quality. However, even in non-perishable industries like retail or manufacturing, FIFO helps maintain accurate financial records by ensuring that the cost of goods sold (COGS) reflects the actual flow of inventory. 

From an accounting perspective, FIFO typically results in lower COGS and higher reported profits during periods of rising costs, as older, lower-cost inventory is accounted for first. On the flip side, this also means higher tax liabilities compared to methods like LIFO (Last-In, First-Out). 

Businesses using FIFO benefit from a logical and transparent inventory tracking system that aligns with real-world product flow. It simplifies inventory valuation, improves cash flow management, and provides a clearer picture of profitability. Throughout this guide, we’ll explore FIFO’s advantages, comparisons with other methods, and its impact on financial statements.

How FIFO Works: A Step-by-Step Explanation 

FIFO (First-In, First-Out) follows a simple yet effective principle: the first inventory items purchased or produced are the first ones to be sold or used. Here’s a step-by-step breakdown of how it works in real-world inventory management:

Step 1: Purchasing or Producing Inventory

A business buys or manufactures goods and adds them to its inventory. Each batch of inventory is recorded with its purchase date and cost.

Step 2: Organizing Inventory for FIFO Flow

Inventory is arranged so that older stock is positioned at the front (or prioritized in software systems) to ensure it gets used or sold first. This is crucial for industries dealing with perishable goods like food and medicine.

Step 3: Selling or Using Inventory

When a sale is made or materials are used in production, the oldest available inventory is deducted first. This maintains a natural inventory flow and prevents product expiration or obsolescence.

Step 4: Recording Cost of Goods Sold (COGS)

In accounting, when inventory is sold, the cost of that sale is based on the cost of the oldest inventory. This means that during inflationary periods, lower-cost inventory is expensed first, leading to lower COGS and higher profits.

Step 5: Repeating the Cycle

As new inventory is purchased, it is added to the system behind older stock, keeping the FIFO method consistent. Businesses continue selling the oldest stock first, ensuring accurate financial reporting and efficient inventory turnover.

By following FIFO, businesses can maintain fresh inventory, improve financial clarity, and reduce losses due to expired or outdated products. 

FIFO vs. LIFO: Key Differences

FIFO vs. LIFO: A Comparative Analysis

When it comes to inventory management and accounting, FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) are two of the most common valuation methods. Each has its own advantages, drawbacks, and financial implications. Here’s a side-by-side comparison to help you understand their key differences:

1. Basic Concept

• FIFO (First-In, First-Out): The oldest inventory is sold or used first, ensuring that newer stock remains in inventory.

• LIFO (Last-In, First-Out): The most recently acquired inventory is sold or used first, leaving older stock in inventory.

2. Impact on Cost of Goods Sold (COGS)

• FIFO: During inflation, older (cheaper) inventory is expensed first, resulting in lower COGS and higher reported profits. 

• LIFO: During inflation, newer (more expensive) inventory is expensed first, leading to higher COGS and lower taxable income. 

3. Effect on Financial Statements

• FIFO: Leads to higher net income and higher inventory valuation on the balance sheet, which can make a company appear more profitable. 

• LIFO: Reduces net income and lowers inventory valuation, which can be beneficial for tax purposes. 

4. Suitability by Industry

• FIFO: Best for businesses dealing with perishable goods (e.g., food, pharmaceuticals) or industries where inventory must move in a logical order. 

• LIFO: More common in industries with non-perishable goods (e.g., oil, metals) where companies want to match current costs with current revenues. 

5. Tax Implications

• FIFO: Can result in higher taxes because profits appear larger when COGS is lower. 

• LIFO: Often reduces tax liabilities by reporting lower profits, but it is not allowed under IFRS (International Financial Reporting Standards). 

Which one should you use, FIFO or LIFO?

The choice between FIFO and LIFO depends on business goals. If a company wants a more accurate reflection of inventory value and higher profits, FIFO is the better option. However, if reducing taxable income is a priority (and local regulations allow it), LIFO might be more beneficial. Regardless of the method used, it’s essential for businesses to consider financial reporting requirements, tax implications, and inventory turnover before making a decision.

FIFO vs. LIFO: Pros and Cons

Both FIFO (First-In, First-Out) and LIFO (Last-In, First-Out) have distinct advantages and disadvantages. The right choice depends on factors like industry, inventory type, and financial goals. Below is a breakdown of their pros and cons.

FIFO: Pros and Cons

Pros: 

• Accurate Inventory Valuation: FIFO ensures inventory is recorded at its most recent cost, reflecting a more realistic financial picture. 

• Higher Reported Profits (During Inflation): Since older, lower-cost inventory is sold first, the cost of goods sold (COGS) remains lower, leading to higher profits. 

• Easier to Implement: FIFO aligns with the natural flow of inventory, making it easier to track and manage. 

• Reduces Risk of Obsolescence: Ensures older stock is used first, preventing waste, spoilage, or outdated inventory. 

• Globally Accepted: FIFO is permitted under both IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles). 

Cons: 

• Higher Taxes: Increased profits lead to higher tax liabilities, especially during inflationary periods. 

• Not Always Reflective of Current Costs: Since older, lower-cost inventory is sold first, FIFO may understate COGS and overstate profitability in inflationary markets. 

LIFO: Pros and Cons

Pros: 

• Lower Tax Burden (During Inflation): LIFO results in higher COGS and lower profits, reducing taxable income. 

• Better Matching of Revenue and Costs: Since newer, higher-cost inventory is sold first, COGS aligns more closely with current market prices. 

Cons: 

• Lower Reported Profits: While reducing taxes, LIFO also results in lower net income, which may be unfavorable to investors. 

• Outdated Inventory Values: Older stock remains on the balance sheet, potentially undervaluing total inventory. 

• Not Allowed Under IFRS: LIFO is not permitted in many countries, including those following IFRS, limiting its use. 

• Potential for Inventory Obsolescence: Older inventory may sit unused for long periods, increasing the risk of obsolescence or spoilage. 

Which Method is Best for Your Business, FIFO or LIFO?

FIFO is ideal for businesses that need accurate inventory valuation and deal with perishable or time-sensitive goods. LIFO, on the other hand, benefits businesses looking to minimize taxes and align costs with revenue in inflationary environments. The best choice depends on financial strategy, industry regulations, and accounting standards.

FIFO in Action: Examples of FIFO Inventory Management

Real-World Example of FIFO in Use

To better understand how FIFO works in practice, let’s take an example from the grocery industry. 

Scenario: A Supermarket’s Dairy Section 

Imagine a supermarket that sells milk with an expiration date. When new milk cartons arrive, store employees place them behind the older ones already on the shelf. Customers naturally grab the milk at the front, ensuring that the oldest stock is sold first. This follows the FIFO method, preventing expired products from remaining on the shelves and reducing waste. 

Financial Perspective: 

Let’s assume the supermarket purchases milk at different prices due to fluctuating supplier costs: 

• January 1: Buys 100 cartons at $2.00 each 

• January 10: Buys 100 cartons at $2.20 each 

• January 20: Buys 100 cartons at $2.50 each 

If the store sells 150 cartons by the end of the month, FIFO dictates that the cost of goods sold (COGS) is calculated based on the oldest inventory first: 

• 100 cartons sold at $2.00 each = $200 

• 50 cartons sold at $2.20 each = $110 

• Total COGS = $310 

The remaining inventory consists of: 

• 50 cartons at $2.20 

• 100 cartons at $2.50 

Since the older stock is always sold first, FIFO provides a more accurate inventory valuation and ensures product freshness. This method is especially useful in industries like food retail, pharmaceuticals, and manufacturing, where inventory must move in a logical order to prevent waste and maintain efficiency.

FIFO Example in Different Industries

FIFO is widely used across various industries to ensure efficient inventory management, maintain product quality, and align financial reporting with real-world stock movement. Below are some industry-specific examples of how FIFO works in practice.

1. Food & Beverage Industry (Perishable Goods) 

• Example: A bakery purchases flour, eggs, and dairy products weekly. To prevent spoilage, the bakery uses FIFO by storing new ingredients behind the older ones, ensuring that the oldest stock is used first. 

• Why FIFO? Prevents expired products, maintains food safety, and minimizes waste. 

2. Retail & E-Commerce (Consumer Goods) 

• Example: A clothing store stocks seasonal fashion items. By using FIFO, they sell older styles first to clear inventory before introducing new collections. 

• Why FIFO? Ensures outdated styles don’t remain unsold and helps with inventory turnover. 

3. Pharmaceutical Industry (Expiration-Sensitive Products) 

• Example: A pharmacy receives medication shipments with different expiration dates. FIFO ensures that the oldest medicine is dispensed first, preventing expired drugs from staying in stock. 

• Why FIFO? Ensures product effectiveness, complies with health regulations, and avoids financial loss due to expired inventory. 

4. Manufacturing Industry (Raw Materials) 

• Example: A car manufacturer orders steel, plastic, and electronic components for production. FIFO ensures that older materials are used before newer shipments, preventing defects due to aging parts. 

• Why FIFO? Reduces waste, prevents material degradation, and keeps production costs predictable. 

5. Electronics Industry (Technology Products) 

• Example: A computer retailer sells smartphones and laptops. Since technology becomes outdated quickly, FIFO ensures older models are sold before newer versions arrive. 

• Why FIFO? Reduces inventory obsolescence and helps maintain competitive pricing. 

No matter the industry, FIFO is a smart choice for businesses that need to manage inventory efficiently, minimize losses, and maintain accurate financial records.

FIFO Inventory Valuation and Financial Impact

How FIFO Affects Financial Statements

The FIFO (First-In, First-Out) method directly impacts a company’s financial statements, influencing Cost of Goods Sold (COGS), inventory valuation, net income, and taxes. Here’s how:

1. Cost of Goods Sold (COGS) 

FIFO assumes that the oldest (cheapest) inventory is sold first. During periods of inflation, when prices are rising: 

• Lower COGS → Older inventory was purchased at a lower cost. 

• Higher Gross Profit → Since COGS is lower, profit margins appear larger. 

• Opposite Effect in Deflation → If prices are falling, FIFO results in higher COGS and lower profits. 

2. Inventory Valuation (Balance Sheet Impact) 

Since newer (more expensive) inventory remains in stock, FIFO results in a higher inventory valuation on the balance sheet compared to LIFO. This means: 

• The company’s assets appear stronger. 

• The inventory valuation is closer to the current market price. 

3. Net Income & Profitability 

• With a lower COGS, FIFO reports higher net income, making a company look more profitable. 

• Investors may view the company as more financially stable due to higher earnings. 

4. Tax Implications 

• Higher net income = Higher taxable income under FIFO. 

• Companies using FIFO may end up paying more in taxes, especially in inflationary periods. 

5. Cash Flow Considerations 

Since FIFO results in higher taxes, it can reduce a company’s available cash. Businesses need to plan accordingly to maintain healthy cash flow.

FIFO in Financial Statements: Key Takeaway 

FIFO is beneficial for financial reporting accuracy and investor confidence but may lead to higher tax obligations. Companies should consider their industry, tax strategy, and cash flow needs when choosing an inventory valuation method. 

FIFO and Tax Implications

The FIFO (First-In, First-Out) inventory valuation method directly impacts a company’s tax obligations, especially during periods of inflation or deflation. Here’s how:

1. Higher Tax Liability During Inflation 

Since FIFO assumes the oldest (cheaper) inventory is sold first, Cost of Goods Sold (COGS) remains lower, and profits appear higher. This leads to: 

• Higher taxable income → Since profits are higher, businesses pay more in taxes. 
• Greater financial transparency → FIFO reflects a company’s actual profit potential, which may be appealing to investors. 
• Reduced cash flow → Higher taxes mean less cash available for reinvestment. 

2. Lower Tax Liability During Deflation 

When inventory costs decrease over time, FIFO results in higher COGS and lower profits, reducing taxable income. This scenario is less common but beneficial for tax savings. 

3. FIFO vs. LIFO for Tax Strategy 

• FIFO results in higher tax payments in inflationary periods because it reports higher profits. 

• LIFO (Last-In, First-Out) reduces taxable income by using the most recent (higher) inventory costs, lowering tax burdens. 

• Businesses in industries with frequent price fluctuations may choose LIFO for tax benefits, but LIFO is not allowed under IFRS (International Financial Reporting Standards). 

4. Global Tax Considerations 

• FIFO is permitted under both IFRS and GAAP (Generally Accepted Accounting Principles). 

• LIFO is banned in many countries following IFRS, making FIFO the preferred method for international businesses. 

FIFO in Tax Implications: Key Takeaway

FIFO can lead to higher tax expenses in times of rising prices, but it provides a more transparent view of a company’s financial health. Businesses should weigh tax implications against financial reporting accuracy when selecting an inventory valuation method. 

Other Inventory Valuation Methods

While FIFO (First-In, First-Out) is widely used, businesses can also choose LIFO, Weighted Average Cost (WAC), or Specific Identification based on their industry, financial goals, and tax strategies. Here’s how they compare:

When to Use FIFO vs. Other Methods

• Use FIFO for perishable goods, products with short shelf lives, or when financial transparency is key.
• Use LIFO in inflationary periods to reduce tax liabilities (only in regions where it’s allowed).
• Use WAC when inventory costs fluctuate and batch tracking is impractical.
• Use Specific Identification for expensive or custom-made items requiring exact cost tracking.

Benefits and Drawbacks of FIFO

Benefits of FIFO

• Prevents Waste & Obsolescence: Ensures older inventory sells first, reducing spoilage.
• Accurate Financial Reporting: Ending inventory reflects current market values.
• Higher Profits During Inflation: Lower COGS leads to higher reported profits.
• Globally Accepted: IFRS & GAAP compliant.
• Simplifies Inventory Tracking: Aligns with natural stock movement.
• Improves Cash Flow: Reduces overstocking, freeing up capital.

Drawbacks of FIFO

• Higher Tax Liabilities in Inflation: Lower COGS results in higher taxable income.
• Cost-Revenue Mismatch: Reports older (lower) costs while ending inventory reflects current prices.
• Not Ideal for Certain Industries: In sectors like oil & gas, LIFO or WAC may better reflect costs.
• Complexity for Large Inventories: Requires accurate tracking of purchase dates.
• Stockpiling High-Cost Inventory: Older, cheaper stock sells first, leaving expensive inventory unsold.

FIFO Benefits & Drawbacks: Key Takeaway

Choosing the right inventory valuation method depends on industry needs, financial strategy, and regulatory compliance. FIFO is best for transparency and real-world stock movement, while LIFO can minimize taxes. WAC simplifies accounting, and Specific Identification suits high-value goods. Some businesses use multiple methods for different product categories to optimize inventory management.

First-In, First-Out (FIFO) FAQs

Conclusion

FIFO (First-In, First-Out) is a tried-and-true inventory management method that helps businesses maintain accurate financial records, reduce waste, and comply with global accounting standards. By ensuring that older stock is sold first, FIFO minimizes spoilage and obsolescence, making it the go-to choice for industries dealing with perishable or high-turnover goods. 

Compared to other methods like LIFO, Weighted Average Cost (WAC), and Specific Identification, FIFO provides a clearer reflection of current inventory value, making it a reliable approach for businesses aiming for better financial reporting and operational efficiency. However, it may result in higher taxable income in inflationary periods, so companies should consider their financial strategy when choosing an inventory valuation method. 

Ultimately, FIFO is simple, effective, and widely accepted, making it an excellent choice for businesses looking to optimize their inventory flow while maintaining compliance and profitability. If you’re handling inventory, leveraging FIFO alongside a strong inventory management system can help streamline operations and drive long-term success.

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