How do you use the FIFO method?
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What accounting method do you use to value your inventory? The inventory valuation method you choose can affect amount of taxes you pay the government. Got your attention now? LIFO and FIFO are the most popular methods used in the United States, but which one is preferable depends on your individual business circumstances. Show
What Is LIFO?LIFO, short for last-in-first-out, means the last items bought are the first ones sold. Cost of sales is determined by the cost of items purchased the most recently. Because this method assumes that the most recently purchased items are sold, the value of the ending inventory is based on the cost of the oldest items. What Is FIFO?FIFO, first in-first out, means the items that were bought first are the first items sold. Cost of sales is determined by the cost of the items purchased the earliest. Ending inventory is valued by the cost of items most recently purchased. FIFO is the most commonly used method in the U.S. A primary reason is that this approach appeals to common sense. Good inventory management would dictate that the oldest goods should be sold first, while the most recently purchased items remain in inventory. Effects of Using Either FIFO or LIFOThe method you use to value the ending inventory determines the cost of goods sold. A lower inventory value results in a higher costs of sales and a lower profit; conversely, a higher ending inventory decreases the cost of goods sold and results in a higher profit. To clarify the application of FIFO and LIFO, look at the following example that shows some calculations. The Flying Pigs Corporation sells roller skates for the swine market and imports them from China. These are the most recent purchases and sales figures:
Calculations For Value of Ending InventoryUnder LIFO, the last units purchased are sold first; this leaves the oldest units at $8 still in inventory. The value of the ending inventory with LIFO: 1,000 units x $8 = $8,000 With FIFO, the oldest units at $8 were sold, leaving the newest units purchased at $11 remaining in inventory. The ending inventory value using FIFO: 1,000 units x $11 = $11,000. Calculations for Cost of Goods SoldThe formula to calculate the cost of goods sold is: Cost of goods sold = Beginning inventory + Inventory purchases - Ending inventory With the LIFO method: Cost of goods sold = $8,000 + $30,000 - $8,000 = $30,000 Applying the FIFO method: Cost of goods sold = $8,000 + $30,000 - $11,000 = $27,000 Effect of LIFO and FIFO on Gross Profit MarginThe formula to calculate your gross profit margin is: Gross profit margin = Total sales - Cost of goods sold From the LIFO method: Gross profit margin = $105,000 - $30,000 = $75,000 With the FIFO method: Gross profit margin = $105,000 = $27,000 = $78,000 This is an example of the effect of using the LIFO method during a period of rising prices. The gross profit margin of $75,000 with LIFO is lower than the $78,000 when using FIFO. This means the company reports lower profits and pays less taxes. It's enough to worry about running your business, selling products, trying to control expenses and motivating employees. But all of your efforts to make a profit could be wiped out by simply making the wrong choice of inventory valuation method. So consider your decision carefully. Manufacturers, retailers, and wholesalers typically carry physical inventory, and their inventory balance may be the largest asset account on the balance sheet. Companies invest large amounts of available cash in inventory, and inventory management decisions have a big impact on cash flow. To operate profitability, you need a solid understanding of inventory valuation methods, including the First-in, first-out (FIFO) method. The inventory valuation method determines cost of goods sold (COGS), profit, and the value of ending inventory. This discussion reviews three common inventory valuation methods, including FIFO, and how they impact business operations. FIFO in actionAs an example throughout, assume that Julie owns Premier Fashions, a clothing retailer. Julie is reviewing October inventory activity for a line of scarves. Assume also that Premier did not have an ending inventory balance of scarves on September 30th:  Growing business owners must understand that the total inventory dollars to account for, and the total units bought and sold, are constant. Premier spent $3,925 to purchase 325 units, and sold 100 during October. That data stays the same, regardless of the inventory valuation method that Julie chooses. The accounting method for inventory value changes the timing of costs. Some inventory costing methods generate a higher COGS than other methods. The three most commonly used inventory management methods are:
Let’s use the same data to calculate the cost of goods sold and ending inventory. This process will help you see how the three methods impact the balance sheet and the income statement. FIFO is the most frequently used method, but we’ll go through all three. Understanding the FIFO methodThe FIFO method assumes that the oldest inventory items are sold first. In a period of rising prices, the older items are less expensive than recent inventory purchases. Premier’s purchases in early October have a lower cost than scarves bought later in the month. Here is cost of goods sold, using the FIFO method: The FIFO method assumes that the first items purchased are sold first, which means that 100 units purchased on October 1st were sold at $10/ unit. When computing the cost of inventory, remember that units are either sold or remain in ending inventory. The total cost to account for is the sum of cost of goods sold and remaining inventory at month end. Here is Premier’s ending inventory balance using the FIFO method of inventory: If you use FIFO inventory accounting, ending inventory includes the most recent costs. In this case, ending inventory includes the 150 units purchased on 10/15, and 75 units bought on 10/17. Prices are rising over time, and the newer units have a higher unit cost than the older units. Finally, the inventory system accounts for the $3,925 in total costs. The $1,000 cost of goods sold plus $2,925 ending inventory equals $3,925. LIFO is a more complex inventory valuation method. Working with the LIFO methodIf you choose the LIFO (last-in, first-out) method, keep these points in mind:
Using the same data, here is Premier’s cost of goods sold, using the LIFO method: Note that the 75 units purchased on October 17th are sold first ($15/unit), followed by 25 units purchased at $12/unit on October 15th. LIFO cost of goods sold totals $1,425, a balance that is higher than the $1,000 FIFO balance. Here is ending inventory using the LIFO method: The flow of inventory moves more expensive items into the cost of goods sold balance, and leaves less expensive items in ending inventory. LIFO ending inventory is $2,500, compared to the $2,925 FIFO balance. Using this cost method, $1,425 cost of goods sold plus $2,500 ending inventory equals $3,925 total costs. Many business owners simplify their bookkeeping by using the weighted average method. Simplify accounting using weighted averageThis method assigns a single cost per unit that is calculated as ($3,925 dollars to account for divided by 325 units purchased), or $12.08 per unit (with rounding). This cost flow assumption uses the same unit cost for cost of goods sold and ending inventory. Here is Premier’s cost of goods sold, using the weighted average method: The 100 units are sold at the weighted average cost of $12.08, for a total of $1,208. Below is ending inventory using the weighted average method: The 225 units are valued at the weighted average cost of $12.08, for a total of $2,718. The sum of $1,208 cost of goods sold plus $2,718 ending inventory equals $3,926 in total costs (a slight difference from total costs, due to rounding). Each method generates a different amount of net income at the end of October. FIFO vs. LIFO: Financial statement impactLet’s assume that the 100 units are sold at $35/unit, or a total market value of $3,500. Here is the October profit calculation, using each of the three methods: Note the following:
The difference in profit, however, is only a matter of timing. FIFO users will sell the more expensive inventory in later months, and LIFO users will sell less expensive inventory in later months. Here’s another way to consider the timing difference. Let’s assume that Premier sells all 325 units at $35/unit, for a total of $11,375. The total profit generated is ($11,375 – $3,925), or $7,450. Total sale price, cost of goods sold, and profit is the same using all three methods. The difference is only in the timing of the inventory costs. FIFO generates a higher profit in the October financial statements but will produce a lower profit in later accounting periods. For a more in-depth look at the differences between the FIFO and LIFO methods, read our in-depth guide here. Here are some final thoughts regarding inventory valuation methods:
Final ThoughtsQuickBooks Enterprise gives you the flexibility to work in FIFO costing in addition to average costing, allowing you to switch between costing methods at any time. Get a more accurate accounting of your COGS by seeing the impact of the cost of labor, as well as freight, insurance, and other expenses. You can also create customizable inventory reports like an inventory valuation support to gain deep insights into your business. With QuickBooks Enterprise, you’ll know how much your inventory is worth so you can make real-time business decisions.
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How do you use FIFO for inventory valuation?The First-in First-out (FIFO) method of inventory valuation is based on the assumption that the sale or usage of goods follows the same order in which they are bought. In other words, under the first-in, first-out method, the earliest purchased or produced goods are sold/removed and expensed first.
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