Why the First In, First Out (FIFO) Method is Important for Business

What is the FIFO Method?

The First In, First Out (FIFO) is an inventory method where the oldest inventory item brought into the storage area is also the first to be sold or used. The reasoning behind this system is that inventory has a shelf life and will expire eventually. The FIFO method aims to follow the natural flow of goods.

Many industries use the FIFO method, including food service and manufacturing. This process ensures that consumer products are safe by following Good Manufacturing Practices (GMPs). Many businesses use the FIFO inventory management method to stay compliant with GMPs.

Pros and Cons of the FIFO Method

There are several pros and cons to the FIFO inventory method. Below are just some of them:

Pros:

• It assumes that materials are supplied in the order of receipt loss.

• There is no unfair profit made from distributing materials at actual cost.

• It’s easy to use and understand.

• It will show the closing stock market value at the current time.

• It’s a simple management method if the quantities are few and the material costs remain consistent.

• This method is beneficial when prices are decreasing.

• It’s a reasonable approach since it follows the typical procedure of first using the supplies received.

Cons:

• The increased likelihood of clerical errors is the trade-off for incorporating more complicated calculations.

• When pricing a requisition, you may need to consider more than one price.

• When costs rise, the issue price does not reflect market pricing since materials come from the earliest consignments.

• Comparing tasks with different start times and prices can be difficult when material costs fluctuate.

• When prices fall, production costs tend to be high. It can result in the cancellation of deals because quotes are too expensive.

How to Use the FIFO Inventory Method

In any business, the Cost of Goods Sold (COGS) is an essential indicator of success, and FIFO is a common method of determining COGS. Companies use it to match the costs of goods sold with the revenue generated from the sale of those goods.

The FIFO method requires businesses to keep track of the cost of each unit of inventory they purchase. The company records the price of each unit sold and calculates the COGS. It’s best to use software platforms to help with this process, as it can be difficult to track costs manually.

The FIFO method is a straightforward way to calculate COGS, but it can be time-consuming if a business has extensive inventories. There are other methods of calculating COGS, such as the weighted average method, which may be more suitable for companies with large stocks.

What Type of Businesses is FIFO Best for and What Aren’t?

Ideal

• Businesses that use a periodic inventory system – A periodic inventory system calculates the quantity of stock at the end of each period with a physical count. FIFO easily attributes expenses to inventory by looking at the most recent purchases.

• Businesses that sell perishable items – FIFO will provide you the most accurate inventory and sales profit calculation if your items follow a FIFO flow, even though the actual movement of products isn’t necessary. It includes companies that sell food or other items with an expiration date, such as medicine.

• Companies that engage in international business – The FIFO inventory valuation method is one of the few options permitted under International Financial Accounting Standards (IFRS). It’s a set of standards companies must follow to report certain transactions and events in their financial statements correctly.

Not Ideal

• Businesses with unstable pricing – Although pricing isn’t always consistent, these companies may prefer average cost calculation to minimize expenses.

• Companies selling high-value goods – Companies that sell large-ticket items, such as car or equipment dealerships, should use specific identification to keep track of each inventory item’s actual cost. It’s often easy to do since high-dollar items usually differ and can be distinguished by serial numbers.