Storing inventory efficiently is one of the key challenges of inventory management, and many companies use the principle of first-in, first-out (FIFO) principle to do so. FIFO is considered to be the ideal way to store inventory. This concept applies not only to inventory management, but also to the accounting process, so it's good to know.
What is FIFO and LIFO?
Let's start with the concept of first-in, first-out. First in, first out is abbreviated as FIFO, which means that the inventory that comes in first goes out first. The opposite of FIFO is LIFO (last in, first out), which means that the inventory that comes in last goes out first. The difference between FIFO and LIFO is which inventory goes out first.
Determining the price and tax of inventory
First, let's take a look at the difference between FIFO and LIFO from an accounting perspective.
Company A and Company B sell the same product. Company A follows the FIFO method and Company B follows the LIFO method.
In January, both companies purchased 5 units of the same product at $1,000 each. In July, they purchased another 5 units of the same product at $2,000 each. Over the course of 6 months, the cost of the product has increased two-fold due to inflation.
Both companies sold 2 units of inventory each during the accounting period, and the selling price of the items was $5,000 per unit.
Company A and Company B have the same products, the same cost to acquire the products, the same quantity sold, and the same selling price. However, because they are using FIFO and LIFO, their gross profits are different. Why is this the case?
The revenue for Company A was $10,000 since it sold 2 products at $5,000 out of the 10 they have on hand. According to the FIFO method, company A sold 2 items it purchased in January, which it acquired at $1,000 each. The COGS (cost of goods sold) is $2,000 ($1,000 X 2 products). Therefore, company A's gross profit is $8,000.
What about Company B? Company B also sold 2 of its 10 inventory during the same period, resulting in revenue of $10,000. However, company B sold the items it purchased in July first, using the LIFO method. Since it purchased the items in July for $2,000 each, its cost of goods sold is $4,000 ($2,000 X 2 products). Therefore, company B's gross profit is $6,000, which is lower than Company A's.
Even if the type of products sold, COGS, quantity sold, selling price are the same, the gross profit will be different depending on your selection of FIFO or LIFO method.
The FIFO and LIFO methods also play a role in determining the value of inventory asset. At the end of the year, companies conduct an inventory audit to determine the actual amount of inventory in their warehouses. This is a very important process to determine the amount of unsold inventory that remains to be sold and to derive the results of the year's sales activities.
Company A and Company B have the same amount of inventory (8 units), but their inventory is valued differently because Company A has 3 units purchased in January ($1,000 X 3) and 5 units purchased in July ($2,000 X 5), while Company B has 5 units purchased in January ($1,000 X 5) and 3 units purchased in July ($2,000 X 3). Even though they sold the same amount, Company A's inventory ($13,000) is valued higher than Company B's inventory ($11,000).
In general, the FIFO method makes gross profit and inventory assets relatively higher than the LIFO method. If gross profits are relatively higher for FIFO, why do some companies prefer to use LIFO? LIFO is used when companies want to save on corporate taxes, because it's assessed as having less gross profit in the same period compared to FIFO. In fact, in the late 20th century in the United States, some companies chose the LIFO method to pay less taxes.
Reduce inventory costs with FIFO
In practice, however, we rarely have to think about choosing between FIFO or LIFO as LIFO is now prohibited by International Fianncial Reporting Standards (IFRS). However, LIFO is allowed under US GAAP (Generally Accepted Accounting Principles) so US companies thus have the option to choose between FIFO, LIFO, and the average cost method.
From an inventory management perspective, it's still useful to be familiar with the FIFO concept. Convenience stores, supermarkets, and restaurants that manage products with a short shelf life often make FIFO the most important principle of their store and warehouse operations, and it's not uncommon for all employees to be thoroughly trained in the strategy of putting older inventory on the most accessible shelves.
The food industry isn't the only industry that uses FIFO as a guiding principle for inventory management. Businesses with inventory usually strive for FIFO rather than the LIFO method which can be detrimental to inventory management because it forces you to keep old inventory on hand. When you keep inventory in a warehouse for a long time, it's easy for it to become damaged due to improper loading or fail due to prolonged storage. This unintentional loss of shrinkage can lead to high inventory costs, so it's best to avoid it.
If you're looking for an inventory management strategy like FIFO that minimizes costs and maximizes efficiency, an inventory management solution like BoxHero is a great choice. With customizable inventory attributes, a convenient barcode system, and an intuitive UI/UX, BoxHero makes inventory management easy and hassle-free.