FIFO Inventory Management | inventory valuation methods

Goods flow vs. cost flow assumption

If you manage inventory, you’re familiar with the term FIFO, an acronym that stands for First In, First Out. Simply put, items are sold in the order in which they arrive at the store or warehouse. FIFO is the most common inventory management method for e-commerce businesses as selling the oldest units before the newer units helps ensure consistent inventory turnover.

What you might not realize is that FIFO is both an inventory management method and an accounting method – and while they are similar, these are two completely different processes. What is the difference? Stay with us to find out.

FIFO as inventory management method

With the FIFO inventory method, when goods arrive at a store, warehouse, or eCommerce fulfillment center, care is taken to move the older goods to the front of the shelf and fill the shelf from the back. This way, the oldest goods are picked first, whether by a customer at a brick-and-mortar store, a forklift at a wholesale distribution center, or an order picker at an e-commerce fulfillment center. In these examples, FIFO is the term used to describe the physical flow of inventory through a company.

The majority of companies use the FIFO method for inventory management as it ensures constant rotation of inventory. Perishable and seasonal goods are sold before they expire or go out of style, reducing inventory losses and the need for discounts.

The alternative to FIFO is the LIFO (Last In, Last Out) inventory method. With the LIFO method, the newest storage units are stored ahead and fetched from the shelf first. This ensures your customers get the latest and greatest version of your product, even if it often means discounting or writing off older stock. This method is often used by technology or electronics companies when new versions of a product make the old version less desirable or obsolete. In order to reduce storage costs and dead stock, older stock must be cleared out regularly. If your product has a predictable shelf life, FIFO is a better choice.

FIFO as inventory valuation method

FIFO and LIFO are not only inventory management methods, they are also inventory valuation methods or “cost flow assumptions” that assign a cost (dollar value) to each unit of inventory. Because wholesale and manufacturing costs are constantly changing, two items with the same SKU sold on the same day may have cost the retailer or e-commerce company two different dollar amounts. Tracking inventory costs is critical as these numbers directly impact profitability – after all, profits are calculated by subtracting the cost of goods sold from revenue. Because unsold or ending inventory is considered an asset at the end of each year, its value must be calculated for financial reporting and tax purposes.

The FIFO inventory valuation method assumes that your inventory will be sold in the order it was received – the key word is “accepts”. With this flow of costs assumption, the cost of the oldest unit on the shelf is assigned to the first unit sold that month and is included in the balance sheet as the cost of goods sold, regardless of which unit was taken off the shelf first or its actual cost. In fact, a company can use an entirely different method to physically manage its inventory but use the FIFO accounting method to calculate the cost of goods sold and the value of the ending inventory at the end of the year.

Since the initial cost of goods purchased tends to increase over time, the FIFO method usually results in the most recently sold units being allocated a lower cost. The lower your cost of goods sold, the higher your profit margins and gross profits. In fact, FIFO profits can be somewhat overstated during periods of inflation as there is a larger gap between costs and revenues. By maximizing gross profit and net income, the FIFO cost flow assumption makes a company’s income statement (P&L) look better at the end of the year, but may not accurately reflect rising costs, shrinking margins, or future earnings.

Assuming costs increase, companies using the FIFO accounting method will see their ending inventory values ​​increase over time. When older, less expensive inventory is sold, higher-value, recently-purchased merchandise stays on the shelf. While unsold inventory is considered an asset on the balance sheet, this metric is carefully monitored. The optics aren’t quite as positive when too much of a company’s cash is tied up in unsellable inventory.

Advantages of the FIFO cost flow assumption

  • Since FIFO is the most commonly used inventory management method, many companies use the FIFO accounting method as it reflects the actual flow of goods.
  • Allocating lower costs to ongoing sales increases profit margins and helps alleviate the pressure that rising costs are putting on operating income.
  • Closing inventory values ​​(assets) increase as costs increase.
  • FIFO maximizes gross profit and net profit at year-end, which is reflected in stock prices and the company’s overall valuation.

Other inventory valuation methods

FIFO is not the only cost flow assumption used. The LIFO cost flow assumption assumes that the newest inventory is sold first. With this method, the cost of the last item purchased is the cost attributed to the first item sold that month. Because each unit is attributed a higher cost, regardless of how long it sits on the shelf, or the actual cost, the gross profit and net income will be lower than with the FIFO method. Ending stock levels are also lower and often undervalued during periods of inflation. Since lower gross profits usually mean lower taxable income, the LIFO method attracts companies looking to lower their tax burden. The LIFO method is legal in the US but prohibited under International Financial Reporting Standards (IFRS).

In addition to the FIFO and LIFO cost flow assumptions, companies can use the weighted average method, which calculates the average cost of all units purchased during the year and uses that dollar value as the COGS (Cost of Goods Sold) for each unit. A fourth method, the Specific Identification Method, tracks the actual cost of each unit. Since the specific method is not based on assumptions about the flow of goods, it is not a cost flow assumption, but only a valuation method.

Businesses can choose from multiple inventory valuation methods, but once chosen, they must use the same method year after year to maintain consistency. US companies must also use the same method for tax reporting that they use for financial reporting.

Software makes everything easier

Whether you’re a growing e-commerce business partnering with a 3PL or fulfillment center to fulfill orders, or a large retailer with massive distribution centers, powerful software platforms make both FIFO inventory management and FIFO processing easy. inventory valuation. A technically advanced 3PL like ShipMonk seamlessly integrates order and inventory management systems with real-time accounting systems. This means inventory managers can track orders, automate reordering and make more informed decisions, while accountants have quick access to COGS and ending inventory values ​​at tax time.

The Final Word on First In, First Out

As we’ve learned, FIFO is a term that’s often used interchangeably to describe both the physical flow of goods through a company and the intangible flow of assets and expenses on a balance sheet. It can be confusing if you are not sure which “flow” is being discussed. (Hint: if an accountant is speaking, it’s probably the latter.)

Whether you are managing physical goods or expenses, FIFO is the most commonly used method. If your products have a predictable shelf life and don’t become obsolete quickly, FIFO is the logical choice for inventory management. It is also the most commonly used inventory accounting method because with the FIFO method, costs logically follow the flow of goods. Of course, many companies choose other accounting methods, but these are the exceptions rather than the rule. At the end of the year, FIFO presents your business in the best light, maximizing profits, net income and assets. Please note that as always you should consult a corporate tax professional to determine the best course of action when it comes to accounting for your inventory management and valuation.

Contact a fulfillment expert at ShipMonk today to learn how a technically advanced 3PL can simplify inventory management and inventory cost calculations.

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