Warehouses often suffer from a costly and preventable problem: inventory spoils or becomes obsolete when newer items are sold first. This mismanagement leads to waste, distorted finances, and eroded profits.
The proven solution is implementing the First In, First Out (FIFO) method. This guide will explain what FIFO is, how it works with clear examples, and how it can transform your operations by reducing waste, simplifying accounting, and protecting your bottom line.
How FIFO Works in Inventory Management
The FIFO method functions on two key levels: the physical flow of goods and the financial flow of costs.
Basic Concept of FIFO
At its core, the First In First Out method operates on a straightforward principle: the first unit of inventory that arrives is the first to leave. This flow mirrors the natural movement of goods for many businesses and helps prevent inventory from becoming obsolete or expiring on the shelf.
FIFO and Inventory Movement
In a physical warehouse, implementing FIFO means organizing your storage so that newer stock is placed behind older stock. This ensures pickers and packers naturally access the oldest items first. For example, in a grocery store warehouse, a new shipment of canned goods would be stocked behind the existing cans, pushing the older ones to the front for sale.
FIFO in Accounting
From an accounting perspective, the FIFO inventory costing method assigns the cost of the oldest inventory to the Cost of Goods Sold (COGS). When prices rise over time (inflation), this means the cheaper, older inventory costs are matched against current revenues. This results in a higher reported gross profit and a higher ending inventory value on the balance sheet, as the remaining inventory is valued at more recent, higher costs.
Benefits of FIFO in Inventory Management
The power of FIFO lies in how its operational and accounting benefits work together to protect profitability and improve operational clarity. Let’s take a closer look:
1. Minimizes Waste and Financial Loss
This is the most tangible benefit. For industries dealing with perishable goods—like food and beverages, pharmaceuticals, or cosmetics—FIFO inventory management is non-negotiable. It ensures items with the earliest expiration dates are sold first, drastically cutting down on waste and lost revenue. A bakery selling day-old bread at a discount is a real-world first in first out example.
2. Accelerates Inventory Cycles
FIFO promotes a healthy, flowing inventory. By systematically moving older stock, businesses avoid dead stock that ties up capital and storage space. This leads to a more efficient inventory turnover ratio, meaning capital isn’t locked in stagnant inventory for long periods.
3. Streamlines Financial Clarity
The FIFO method of inventory valuation is straightforward and easy to understand, making financial statements more transparent. It aligns with the actual flow of goods in many industries, so the reported costs feel logical. This simplicity also makes it easier for managers to track costs and profitability.
Limitations of FIFO
Despite its advantages, the FIFO method introduces specific challenges, including potential tax inefficiencies, higher operational costs, and a mismatch for certain types of inventory.
Impact of Inflation on Profit Margins – During periods of high inflation, FIFO can inflate net income. By charging older, lower costs against current sales, reported profits are higher. This leads to a higher tax liability, which can be a cash flow disadvantage for the business.
Higher Tax Burden During Inflation – A direct consequence of inflated paper profits is increased taxable income. Businesses may end up paying taxes on profits that don't correspond to the current, higher cost of replacing the sold inventory, potentially straining cash reserves.
Increased Storage and Handling Costs – Implementing a true FIFO flow often requires more sophisticated warehouse layout and organization (e.g., flow-through racking, dedicated lanes), which can incur higher initial setup and ongoing handling costs compared to simpler storage methods.
Not Ideal for All Product Types – For non-perishable goods or industries where the newest product is the most desirable (like certain bulk materials or industries where LIFO is permitted for tax purposes), FIFO may not offer the best financial or operational advantage.
Less Effective for Bulky or Non-Dated Goods – For large, homogeneous, or non-perishable items (e.g., lumber, metals), the extra effort and cost to enforce a strict FIFO sequence may not yield a worthwhile return, making other methods like specific identification or weighted-average cost more practical.
When to Use FIFO in Inventory
Understanding when to implement FIFO is crucial, as its effectiveness depends heavily on your product type, industry norms, and financial objectives.
Ideal Industries for FIFO
Retail (Especially Perishables) – FIFO is the standard for grocers, florists, and any retailer selling goods with expiration dates. It is essential for minimizing spoilage and ensuring customers receive fresh products, directly protecting revenue and brand reputation.
Food and Beverage – This industry is synonymous with FIFO. From restaurants managing ingredient stock to distributors handling canned goods, the method is non-negotiable for food safety, regulatory compliance, and cost control by systematically using items before they expire.
Healthcare and Pharmaceuticals – Patient safety and strict regulatory standards mandate precise inventory tracking. FIFO ensures that medical supplies, vaccines, and medications with the earliest shelf-life are used first, preventing the use of expired, ineffective, or potentially dangerous products.
High-Tech or Fashion (Fast-Moving Consumer Goods) – For products with rapid obsolescence due to changing trends or constant innovation—like smartphones, seasonal apparel, or gaming consoles—FIFO helps clear out older models before they become dead stock, aligning inventory with market demand.
Scenarios Where FIFO is Beneficial
| Scenario | Key Benefit & Reasoning |
| Preventing Spoilage is Critical | Provides a systematic, fail-safe process to rotate stock, making it the most logical and essential method for managing perishable inventory and reducing waste. |
| During Periods of Steady Inflation | Can be financially advantageous on paper, as it yields a higher reported gross profit and a higher ending inventory value on the balance sheet by matching older, lower costs against current revenue. |
| Seeking Financial Statement Clarity | The straightforward approach of matching the oldest costs to revenue often aligns with the physical flow of goods, making cost patterns and profitability easier for stakeholders to understand. |
| Product Traceability is Important | Simplifies tracking a product's journey through the warehouse by systematically moving the oldest stock first, aiding in quality control and making batch tracing or recalls more manageable. |
How to Implement FIFO in Your Business
Successfully implementing FIFO requires a deliberate strategy that integrates your physical warehouse layout, digital tools, and team procedures.
1. Organize Your Warehouse Layout
Design your warehouse for linear product movement. Use clear labeling with received dates or expiration dates. Implement shelving systems that allow older products to roll forward as new stock is added behind them.
2. Use Technology to Enforce FIFO
Modern inventory management software is indispensable. Systems can automatically track lot numbers, manufacture dates, and costs. They can generate pick lists that prioritize older stock, ensuring the FIFO method step by step is followed accurately.
For platforms like Magento or Shopify, extensions and best practices can enforce FIFO principles. Learn more about streamlining this process in our guides on Magento inventory management and Shopify inventory management.
3. Train Employees and Standardize Processes
Your team must understand the "why" behind FIFO. Establish clear Standard Operating Procedures (SOPs) for receiving, storing, and picking inventory. Regular training and audits ensure compliance.
Alternatives to FIFO
While FIFO is advantageous for many businesses, other inventory costing methods can better serve specific financial strategies or operational realities.
LIFO (Last In, First Out)
The LIFO method assumes the newest inventory is sold first. Primarily used in the United States for tax advantages during inflation (as it matches higher recent costs with revenue, lowering taxable income), it often doesn’t reflect the physical flow of goods.
Average Cost Method
This method smooths out price fluctuations by calculating a weighted average cost for all units available for sale during the period, then applying this average to both COGS and ending inventory. It’s simple and useful for indistinguishable inventory items.
Specific Identification Method
This method tracks the exact cost of each specific item sold, making it ideal for businesses with high-value, unique inventory like automobiles, jewelry, or custom machinery. It provides the most accurate matching of costs and revenues but requires significant tracking effort and is only practical for low-volume, distinct items.
Key Takeaways
The FIFO inventory method is more than an accounting choice, it's a strategic approach to warehouse management that promotes efficiency, reduces waste, and provides clear financial insight. While it has limitations, particularly in inflationary environments, its benefits for product freshness, inventory turnover, and reporting clarity make it the default and most logical choice for a vast range of industries.
By understanding how to calculate FIFO, organizing your storage, and leveraging technology, you can harness the advantages of the FIFO method to build a more resilient and profitable operation.
Frequently Asked Questions
A supermarket is a classic example. Milk cartons with tomorrow's expiration date are moved to the front of the cooler, while new shipments with a later date are stocked behind them. This ensures the oldest milk is sold first.
FIFO – First In, First Out. Oldest inventory is used/sold first.
LIFO – Last In, First Out. Newest inventory is used/sold first.
FEFO – First Expired, First Out. A variation used for perishables where the inventory closest to its expiration date is moved first, regardless of when it was received.
It is used to reduce spoilage/waste, reflect the natural flow of goods in many businesses, simplify inventory tracking, and provide a higher valuation of ending inventory and profit during periods of rising prices.
Identify – Track the cost and acquisition date of each inventory batch.
Record Sales – When a sale occurs, assign the cost of the oldest available batch to that item.
Calculate COGS – Sum the costs of the oldest batches used to fulfill all sales in the period.
Value Remaining Inventory – The ending inventory value is based on the costs of the most recently purchased batches.
