Industry, regulatory and tax considerations
Accountants use “inventoriable costs” to define all expenses required to obtain inventory and prepare the items for sale. For retailers and wholesalers, the largest inventoriable cost is the purchase cost.
On the other hand, manufacturers create products and must account for the material, labor, and overhead costs incurred to produce the units and store them in inventory for resale.
You should also know that Generally Accepted Accounting Principles [GAAP] allow businesses to use FIFO or LIFO methods. However, International Financial Reporting Standards [IFRS] permits firms to use FIFO, but not LIFO. Check with your CPA to determine which regulations apply to your business.
Lastly, the inventory method you choose may impact your income tax liability. To explain, assume that Sterling sells 300 shirts on December 31st, 2021.
The FIFO and LIFO compute the different cost of goods sold balances, and the amount of profit will be different on December 31st, 2021. As a result, the 2021 profit on shirt sales will be different, along with the income tax liability. Again, these are short-term differences that are eliminated when all of the shirts are sold.
FIFO is the easiest method to use, regardless of industry, and this inventory valuation method complies with GAAP and IFRS. Use the FIFO method for your inventory transactions.
Accounting for inventory is essential—and proper inventory management helps you increase profits, leverage technology to work more productively, and to reduce the risk of error.
First-in, first-out, also known as the FIFO inventory method, is one of four different ways to assign costs to ending inventory. FIFO assumes that the first items purchased are sold first. Companies must make an assumption about their flow of inventory goods to assign a cost to the inventory remaining at the end of the year.
In this article, we’ll discuss how to calculate the value of inventory and the cost of goods sold [COGS] using the FIFO method as well as the advantages and disadvantages of using the FIFO inventory method.
How the FIFO Inventory Method Works
FIFO is one of four popular inventory valuation methods, along with specific identification, average cost, and LIFO. The FIFO inventory method assumes that the first items put into inventory will be the first items sold. Under this method, the inventory that remains on the shelf at the end of the month or year will be assigned the cost of the most recent purchases.
Example of FIFO:
If a retailer purchases 100 snow globes each month and has 80 snow globes in inventory at the end of the year, then those 80 snow globes will be assigned a cost per unit equal to the December purchase price. If there were 120 snow globes left at the end of the year, 100 would be valued at the December purchase price and the other 20 would be valued at the November purchase price. It makes no difference when the items in the ending inventory were purchased.
Most companies buy inventory throughout the year at various prices. They sell most of their inventory but have some left at the end of the year. An inventory valuation method, such as FIFO determines what cost to assign to the units in ending inventory. This helps when it isn’t always straightforward if many identical units were purchased during the year for various prices.
What Type of Business FIFO Is Best For
- Businesses with a periodic inventory system: With a periodic inventory system, the quantity of inventory is determined at the end of each period with a physical count. With FIFO, costs can be assigned to the inventory easily by looking at the most recent purchases.
- Businesses that sell perishable items and sell the oldest items first: While the actual flow of goods isn’t required to match your FIFO assumption, FIFO will give you the most accurate calculation of your cost of inventory and sales profit if your goods do follow a FIFO flow. This includes businesses that sell food or other products with an expiration date, like medication.
- Companies that do business internationally: FIFO is one of the few inventory valuation methods allowed under international financial accounting standards [IFRS]. Another popular method, last-in, first-out [LIFO], isn’t allowed.
What Type of Business FIFO Is Not Right For
- Businesses with highly fluctuating prices: Because pricing isn’t always consistent, these types of businesses might prefer the average cost method to smooth out costs.
- Businesses that use LIFO on their tax return: Some businesses choose last-in, first-out [LIFO] inventory accounting for tax purposes, as it usually results in lower taxable income if the price of inventory is increasing over time. If you choose LIFO for tax purposes, the IRS requires you to also use it for your books.
- Businesses selling high-value items: Companies like car and equipment dealers that sell high-dollar items should generally use specific identification to keep track of each inventory item’s actual cost. This is usually pretty straightforward, as high-dollar items tend not to be identical to each other and can be distinguished by serial numbers.
Advantages & Disadvantages of Using the FIFO Method
How To Calculate Inventory Value Using the FIFO Method
Let’s assume that 100 gallons of milk are in stock at your store:
Beginning Inventory: 100 gallons at $2 each = $200.00
Now let’s say that we make the following purchases of milk:
Purchase #1: 10 gallons at $2.50 each = $25.00
Purchase #2: 20 gallons at $3.00 each = $60.00
Our new inventory quantity available for sale during the period is 130 gallons [100+10+20], with a cost of $285.00 [$200 +$25+$60].
Assume 80 gallons of milk were sold during the year, leaving 50 gallons in inventory. With FIFO you calculate the cost of those remaining 50 gallons using the most recent prices. Twenty gallons in ending inventory were purchased for $3, 10 gallons were purchased for $2.50, and 20 gallons were in beginning inventory for $2. Therefore, your total cost of ending inventory is $125 [$60 + $25 + $40 = $125].
How To Calculate COGS Using the FIFO Method
Let’s continue with our milk example and calculate the cost of the 80 gallons that were sold during the year. In this simple example, it’s pretty easy to see that all 80 gallons sold were in inventory at the beginning of the year with a cost of $2 each. Therefore, the COGS for the 80 gallons of milk is $160.
A more common way to calculate the COGS under FIFO is to subtract the cost of ending inventory from the cost of total goods available for sale. As given above, the total cost of the 130 gallons available for sale during the period was $285. Subtracting the cost of ending inventory of $125 leaves you with $160 for the COGS.
Bottom Line
While it’s useful to have a basic understanding of how to use the FIFO inventory method, we strongly recommend using accounting software like QuickBooks Online Plus. It’ll do all of the tedious calculations for you in the background automatically in real-time. This will ensure that your balance sheet will always be up to date with the current cost of your inventory, and your profit and loss [P&L] statement will reflect the most recent COGS and profit numbers.