FIFO Inventory Management Method, Explained

When it comes to deciding how to manage the inventory of your warehouse or small business, the most intuitive approach is the best. This, of course, is “first-in-first-out,” or “FIFO” inventory management, where the oldest inventory you have acquired is sold prior to inventory you have acquired more recently. In this guide to the FIFO inventory-management method, we’ll explain how this method benefits not only your warehousing, but also the quality of your merchandise, as well as making life easier for your accountants and the IRS.

Last vs. First

First, let’s define what FIFO is by understanding what it is not. The alternative approach to inventory management and valuation is last-in-first-out, or LIFO, where the assumption is that the inventory you have purchased most recently is in turn the inventory that you will sell first. For example, let’s say you have received three monthly shipments of plungers, with plungers arriving in January, February, and March. Under LIFO, you would sell your March plungers first, followed by February and January, and when April’s shipment arrives, it would be a priority to sell April’s plungers ahead of any remaining plungers from the three prior months. Of course, whether all these transactions transpire is largely immaterial in reality—what matters is that you would record your most recent arrivals as having been sold first for bookkeeping and documentation purposes. When wholesale costs rise, it can be advantageous for tax purposes to claim a LIFO strategy, because the higher expenses on paper will depress your net income and therefore your tax bill. This is attractive to some businesses, but can lead to higher scrutiny of your books during tax preparation time. To avoid this, many businesses opt for traditional first-in-first-out management instead. Outside of the United States, LIFO is not even an option, thus dictating FIFO instead.

High Transparency

While both FIFO and LIFO are sanctioned under the United States’ generally accepted accounting principles, or GAAP, opting for FIFO will make your life and the lives of your associated tax professionals much easier. Perhaps more importantly, committing to FIFO is something both financial institutions and potential investors will find commendable, as this method lends very high transparency to your books. Lenders and investors will be very interested to know what your true revenues and expenses are. LIFO can obfuscate this, and not to their benefit. Employing FIFO management precludes a certain degree of strategic manipulation of your expenses, but if you find yourself attracting or requiring additional cashflow, honesty is the best policy.

Examples of FIFO

Having explained LIFO, let’s give an example of FIFO. Let’s say now that you are in the candle business, producing and selling a variety of scented candles. In January, you buy your bulk wax, fragrances, and glass jars, paying $5000 in total for your supplies. However, in February, your fragrance supplier has had to raise prices a bit, in turn raising your monthly expenses to $6000. In March, a snafu at the glass factory means they’re passing those costs to you, raising the total of March’s raw materials to $6500. As you bring your raw materials together to form your scented candles, your suggested retail price will reflect the costs of the materials you purchased, with candles from your earlier lots costing less than more recent candles, the materials for which have experienced increases in price. Under first-in-first-out management, you will first sell your candles from the January lot, with their lower costs, until that you have exhausted that lot. At this point, you will begin to sell February inventory with its higher cost per item, followed by March. This defers the higher expenses of acquisition, unlike last-in-first-out, which shoulders those expenses upfront for the tax benefit. It also reduces the impact of inflation on your business.

Putting FIFO Into Practice

FIFO management doesn’t have to exist solely on paper. It may be genuinely beneficial to sell your oldest inventory before you sell more recent arrivals. To this end, you can expand your FIFO method from the theoretical to the tangible with further organizational strategies. Color-coding your inventory can help clarify which items belong to which lots, therefore indicating which ones need to sell first. Removable colored tape is a simple and easy way to color-code your inventory in a way that won’t be distracting to consumers, nor will it be clearly indicative of your management strategy—no one wants to be under the impression that they’re buying “old” inventory when they could be buying something newer.

Which Businesses Benefit Most From FIFO?

If you’re outside the United States where the LIFO method is not an option, the answer is “all of them.” But if you have the choice between FIFO and LIFO, there are instances in which going first-in-first-out is particularly advantageous. If you operate a restaurant, where much of the inventory in question is perishable, your kitchen staff will want to use up anything with an expiration date before progressing to new supplies. This prevents spoilage and waste, which would put a big loss on your books. First-in-first-out is not only good bookkeeping in restaurants—it’s also real-life common sense. The same goes for florists, who often deal with goods even more perishable than flour and eggs. And if you’re an entrepreneur who’s looking to attract new investors, with or without appearing on popular TV shows about start-up investment, the obfuscatory nature of last-in-first-out inventory management could be detrimental to your chances of securing capital. As long as you’re in a business where the depreciation of goods matters, staying true to first-in-first-out is your best practice.

Owning and operating a small business is exciting, but the obligatory accounting side of running a small business is usually the least exciting part of the job. Now that you have a better understanding of the FIFO inventory-management method, explained in both its theoretical bookkeeping and real-life applications, you can go forward with a management approach that is best suited for you and your company. And if you need to build the bridge between the abstract and the tangible when it comes to knowing what’s first and what’s last, Chromalabel has the products to easily and colorfully assist you.

FIFO Inventory Management Method, Explained