The principles of first-in, first-out (FIFO) stock rotation are likely familiar to you at home, whether you prioritize cooking with last week’s groceries before eating the produce you’ve just loaded into the fridge, or use up a half-full bottle of shampoo before cracking open a new one. They’re also critical for anyone operating a business that relies on perishable products that have a limited shelf life. Ahead, learn all about the benefits of this widely used inventory management and valuation system, and how to implement it in your business.
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What is the first-in, first-out (FIFO) method of stock rotation?
First-in, first-out (FIFO) stock rotation is an inventory management and accounting method that’s based on the principle that the first items added to inventory should be the first ones to be sold or used. This strategy is particularly important in industries such as food and skin care that sell perishable products.
For example, let’s say your ecommerce skincare company sells a face mask made with natural ingredients that expire after a year. If you start shipping out inventory you received a week ago before you’ve gone through the inventory you’ve had for months, the older products may expire in your warehouse before you’re able to get them to customers—leading to losses. This is even more important for food establishments, as abiding by expiration dates helps ensure food safety and food hygiene standards.
Even businesses that don’t sell perishable goods can benefit from the first-in, first-out method. FIFO can help you more accurately measure the value of your inventory and calculate your cost of goods sold (COGS).
Benefits of FIFO
There are two main benefits of implementing FIFO: ensuring product freshness and improving inventory valuation.
The most obvious benefit of implementing the FIFO method of stock rotation is that it ensures product freshness. This is a critical factor, especially in industries where products have a limited shelf life or expiration date. This method ensures that the oldest inventory is sold first, reducing the risk of products becoming obsolete, spoiled, or expired, improving reliability and customer satisfaction. FIFO stock rotation also ensures that products that are either seasonal or that become obsolete quickly are on shelves in time.
The FIFO inventory valuation method can help track your cost of goods sold (COGS)—the direct costs incurred in producing the goods you sell during a specific period. This can include the cost of buying raw materials, labor, and other production costs. An accurate understanding of your COGS is necessary to calculate gross profit:
Revenue − COGS = gross profit
Since costs fluctuate with time, FIFO helps match the COGS of a specific batch or shipment with its corresponding revenue. This is especially important during times of increased inflation, when COGS changes more rapidly.
How to calculate COGS using FIFO
To calculate your business’s cost of goods sold using the FIFO inventory valuation method, take the purchase price of your oldest batch of inventory and multiply it by the number of units of inventory sold from this same batch of goods. In other words:
Purchase price per unit × units of inventory sold = COGS
If the inventory cost increases or decreases, you must calculate the COGS for that batch separately and factor that into your inventory accounting. For instance, if you purchase 100 units of inventory at $5 each and then later purchase another 100 units at $6 each, you will need to account for the price fluctuation in your calculation.
If you’re using the FIFO method and have sold 150 units total, you can use the $5 purchase price for the first 100 units sold and multiply the remaining inventory (50 units) by the $6 purchase price. For 150 units, your COGS would be $800:
(5 × 100) + (6 × 50) = $800
You can also use other inventory valuation methods, such as the last-in, last-out (LIFO) method or the average cost method to calculate COGS, depending on your accounting priorities.
How to implement FIFO
- Organize your inventory system
- Train your staff on FIFO principles
- Create a FIFO schedule and action plan
- Handle exceptions and challenges
Implementing FIFO requires solid organization systems and collaboration throughout your business. Inventory management software can also help you track and automate the process. Here’s how to implement FIFO:
1. Organize your inventory system
Whether you implement FIFO manually or with the help of an inventory management software, you need to organize your inventory. Sort and label your inventory by purchase dates, and consider positioning older items at the front of shelves for convenient access.
2. Train your staff on FIFO principles
To successfully use the FIFO method, you will need the cooperation of your staff. Make sure your employees understand the importance of using older items first, especially if they’re food workers or if the products you sell have perishable ingredients.
3. Create a FIFO schedule and action plan
To ensure you continue to adhere to the FIFO method after its initial implementation, develop a schedule for regular inventory checks, and set guidelines for effectively restocking shelves and rotating inventory. Seek feedback from staff and make adjustments as needed.
4. Handle exceptions and challenges
As beneficial as the FIFO method can be, almost every business will face situations in which they must make exceptions, such as when inventory or raw materials are damaged.
If your business allows for special orders, such as custom or expedited products, they likely need to be handled separately, outside of the FIFO system. It’s crucial to prepare contingencies and protocols for likely scenarios, so production isn’t disrupted when these exceptions occur.
In all special cases, communication and documentation are key. Make sure employees are trained to recognize and handle exceptions and maintain detailed records of any exceptions, including how they were resolved.
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Challenges of using FIFO stock rotation
Implementing FIFO inventory management, while advantageous for product freshness and accurate cost calculations, presents some challenges. Maintaining precise inventory records for each item’s entry date can be labor-intensive and error-prone. Variability in product shelf lives, inconsistent supplier deliveries, and storage space constraints can also complicate the strict application of FIFO. You may also need to make exceptions for damaged goods or special orders. It can help to create carefully defined protocols to avoid disrupting the FIFO system in these situations.
Another drawback of the FIFO inventory valuation method is its potential to inflate profits during periods of high inflation. When the lower cost of older inventory is counted first, it can create a distorted view of your net income and inventory levels. This is not only confusing for internal financial statements, but if it looks like your income is higher than it is, you may have to pay correspondingly higher taxes.
First in, first out stock rotation FAQ
What types of products benefit most from FIFO stock rotation?
Perishable products, such as food and cosmetics, benefit the most from the FIFO inventory management system, because selling the oldest inventory first increases the chance that items are sold before their expiration date and that customers reliably receive fresh, high-quality products.
How can inventory management software help with FIFO stock rotation?
Inventory management software can help automate FIFO by tracking product arrival dates and linking them to sales. It ensures accurate stock rotation, reduces manual errors, and provides real-time insights.
Can FIFO be applied to non-perishable products?
Yes, while the FIFO method is especially important for managing an inventory of perishable products, it can benefit all types of products because it can help businesses more accurately make inventory valuations.
How does FIFO impact inventory turnover and carrying costs?
FIFO increases inventory turnover by prioritizing older items for sale, reducing holding time. It can lower carrying costs as products move faster, and decrease storage expenses and potential obsolescence costs.
Are there any legal or regulatory requirements related to FIFO stock rotation?
In sectors like food and pharmaceuticals, FIFO stock rotation is mandated to ensure product freshness and food safety.