Under FIFO, your Cost of Goods Sold (COGS) will be calculated using the unit cost of the oldest inventory first. The value of your ending inventory will then be based on the most recent inventory you purchased.
How FIFO works (an example)
Bertie’s Breakfast Bars bought 3 batches of their signature bars ahead of a trade show:
- She bought batch 1 first for 100 bars at $2.00 a bar
- She bought batch 2 second for 300 bars at $1.00 a bar
- She bought batch 3 last for 200 bars at $1.75 a bar
While at the trade show, Bertie does gangbusters and sells 300 breakfast bars. Before kicking back and relaxing, she wants to figure out what her net income was for the trade show. To do this, Bertie uses the FIFO method to figure out her Cost of Goods Sold.
The oldest bars in her inventory were from batch 1 so she will count 100 at the unit cost of batch 1, $2.00. For the remaining 200 she sold uses the unit cost of batch 2, $1.00. To calculate her COGS for the trade show, Bertie will count 100 bars at $2.00 and 200 at $1.50.
Bertie’s Cost of Goods Sold = (100 bars x $2.00) + (200 bars x $1.00)
Bertie’s Cost of Goods Sold = $400
FIFO method and inventory valuation
Bertie also wants to know the value of her remaining inventory—she wants her balance sheet to be accurate. To do this, she counts up the value of her remaining inventory.
• She has 100 bars left from batch 2 at $1.00 a bar
• She has the full 200 bars left of batch 3 at $1.75 a bar
Bertie’s ending inventory = (100 bars x 1.00) + (200 bars x 1.75)
Bertie’s ending inventory = $450
Bertie had 300 bars left over—the same amount she sold. But when using the first in, first out method, Bertie’s ending inventory value is higher than her Cost of Goods Sold from the trade show. This is because her newest inventory cost more than her oldest inventory.
Why is choosing a method of inventory valuation important?
If your inventory costs are increasing over time, using the FIFO method and assuming you’re selling the oldest inventory first will mean counting the cheapest inventory first. This will reduce your Cost of Goods Sold, increasing your net income. You will also have a higher ending inventory value on your balance sheet, increasing your assets. This can benefit early businesses looking to get loans and funding from investors.
But if your inventory costs are decreasing over time, using the FIFO method will increase your Cost of Goods Sold, reducing your net income. This can benefit businesses looking to decrease their taxable income at year end.
If your inventory costs don’t really change, choosing a method of inventory valuation won’t seem important. After all, if the first piece of inventory you bought was the same value as the last piece of inventory, there will be no difference in the calculation of your Cost of Goods Sold or ending inventory.
But regardless of whether your inventory costs are changing or not, the IRS requires you to choose a method of accounting for inventory that’s consistent year over year. You must use the same method for reporting your inventory across all of your financial statements and your tax return. If you want to change your inventory accounting practices, you must fill out and submit IRS Form 3115.
Choosing—and sticking to—an inventory valuation method to measure these amounts is essential in keeping tax-ready books. If you want tax ready books to be a worry of the past, try Bench. We reconcile, review, and repeat until your finances are CPA ready so you don’t have to.
Further reading: Inventory Management for Small Business: A Simple Guide
Alternatives to the FIFO method
There are three other valuation methods that small businesses typically use.
Last In, First Out (LIFO)
The opposite to FIFO, is LIFO which is when you assume you sell the most recent inventory first. This is favored by businesses with increasing inventory costs as a way of keeping their Cost of Goods Sold high and their taxable income low.
Average cost inventory
The average cost method is the simplest as it assigns the same cost to each item. The average cost is found by dividing the total cost of inventory by the total count of inventory.
Specific inventory tracing
If you’re a business that has a low volume of sales looking for the most amount of detail, specific inventory tracing has the insight you’ll need. But it requires tracking every cost that goes into each individual piece of inventory.
How to track inventory
Whether you need an eagle eye into the hundreds of items you sell or if you just want to stay on top of your stock, there’s an inventory management solution that’s right for you. If you sell online, most POS systems like Shopify will track inventory for you. If you’re wanting to try it for yourself, there are free templates available online. If you’re ready to try out a dedicated inventory system, Zoho Inventory is free to start.
For more bookkeeping basics:
- Working Capital: What It Is and How to Calculate It
- What Is Depreciation? and How Do You Calculate It?
- Liquidity: A Simple Guide for Businesses
- How to Read (and Analyze) Financial Statements
For more software solutions: