Calculating Cost of Goods Sold with the FIFO Inventory Method
Calculating your inventory lets you keep an eye on your business’ performance and its overall assets. Unsold inventory is considered an asset, and when it’s sitting there, you need to know exactly how it affects your bottom line as well as how it relates to taxes. This calculation is known as Cost of Goods Sold, or COGS.
The cost will account for all of the products that you sell and will eventually yield profits from. Businesses have two accounting methods of calculating COGS: First In, First Out (FIFO) and Average Cost Method (ACM), also known as weighted average.
Both have their advantages, but if you want to have an accurate inventory value, we recommend the FIFO inventory method. Inventory can fluctuate in costs over time and it’s important to accurately calculate those changes..
Using The FIFO Inventory Method
Following FIFO, a company assumes that their oldest items will sell first, even if they haven’t actually sold first. The FIFO inventory method is popular with grocery stores and other stores that sell perishables, but it has plenty of applications for other retailers as well.
As a retailer, you probably aren’t ordering every bit of your inventory at the same time for a number of reasons.
- The available inventory from vendors consistently changes
- You don’t have the room for a huge stock of inventory all at once
- Inventory is seasonal, and you won’t stock it when out of season
With all of these variables affecting inventory, it’s probable that inventory will flow consistently into your store rather than arriving as one huge order. You need to know the cost of all of the inventory. With FIFO, you calculate your stock at its oldest value, then you will have higher and more accurate valuations of inventory. You will list your cost as equal to the cost of the oldest items on your income statement.
Calculating inventory Using FIFO
Let’s look at how using the FIFO inventory method can be calculated in a bookstore.
You have three sets of bookends with unit costs of $15, $25 and $10, all required in that order. All of the bookends were acquired in the month of April. You sold the $15 and the $25 bookends.
FIFO means you would calculate your COGS as $15 + $25 = $40 as your COGs expense. Your remaining bookend set, the one priced at $10, is the cost of the most recent merchandise.
FIFO Versus ACM
With the ACM calculation, we’ll use the same bookstore example. You have the same three sets of bookends. Again, their prices are $15, $25 and $10. To get your COGS, you would take the average cost of the three bookends.
$15 + $25 +$=50. You’ll next divide $50 by 3 (the amount of units) to find the average: $33 and list the products at that price valuation.
FIFO calculates COGS at a much more precise level than ACM because it accounts for each item whereas ACM only uses the average of similar products.
Calculating inventory with ACM can be helpful if you have a large number of products and want to calculate faster, but the FIFO inventory method provides more long-term benefits over the course of your business.
Using ACM can also be tricky because differentiating between identicals may be incorrect, and the calculation will be thrown off entirely. The price of each individual item is also hard to track with ACM and if prices vary often, you may underprice items.
How FIFO Helps Your Bottom Line
Account for inflation
Calculating for inflation is a part of owning a business. Using FIFO helps you mitigate your inflation losses because, as the cost of goods rises, you’re able to adjust your prices of the previous stock and sell it at a higher cost as inflation dictates.
Calculate goods that increase in demand
Business owners need to look at their inventory in a way to anticipate what products they need to purchase and the quantity to meet current customer demand. Using FIFO will help you understand and identify inventory trends, especially if you operate with seasonal inventory. FIFO is also adaptable to both types of inventory cycles: perpetual (inventory taken year-round constantly) or periodic (inventory taken certain times of the year)
FIFO inventory method helps you account for the moments when costs rise. ACM won’t let you do the same — instead, the COGs in ACM is only calculated again when you purchase a new product. By that time though, the price likely changed.
Account for unsellable inventory
You can also use FIFO value calculation as a way to predict your cash flow, especially as your previous FIFO inventory calculations can create a benchmark and you’re getting real-time data. When your inventory can’t be sold or is out of date, then it becomes obsolete, but the FIFO inventory method helps you reduce the risk of having high amounts of obsolete inventory.
Support marketing with statistics
With FIFO, you can figure out how to build marketing strategies based on the data as well, such as running a promotion on a popular item. You will also get a real-time look at the inventory flow so you can improve your margins and buying costs, thereby affecting your bottom line.
ACM will make it harder to spot the trends as it relies on averages, and you could even be stuck in a situation where you’re selling products at a price that hardly delivers any profit.
Maintain accurate inventory records
When you approach investors or need to meet with an accountant, your income sheet will also have the current market prices, thereby giving a more accurate picture of your business’ performance. The FIFO inventory method can also be the mandated method by the IRS depending on your business and how it operates so knowing the difference between FIFO and ACM is important.
FIFO inventory method and your business
If you haven’t learned FIFO inventory calculation yet as a way of calculating your inventory, it’s time to start. Erply POS uses FIFO and features its practices built into the system to offer you a no-hassle way of calculating your inventory valuation.