How the FIFO Method Supports Accuracy and Efficiency in Inventory Management

Millions of us go through this situation every time we shop, because supermarkets naturally want to sell the goods that are about to expire while they still can. And this is a great example of FIFO: from the store’s point of view, they want to sell their goods in more or less the same order that they received them from their suppliers.

This same principle can be applied throughout the world of retail, including in how e-commerce businesses manage their inventory. In this guide, we’ll explore FIFO’s meaning, how it works in practice, and how your operation can be transformed as a result.

Jump to:

• What Does FIFO Stand For and How Does It Work?
• Why Is FIFO Inventory Management Important?
• How Is The FIFO System Beneficial for E-Commerce Businesses?
• What Should I Be Aware of When Using the FIFO Method?
• FAQs

What Does FIFO Stand For and How Does It Work?

FIFO, quite simply, means ‘first in first out’ inventory management, where the first items received by the retailer are the first ones to be sold. However, from an accounting perspective, things can be a little bit more complicated than that.

Under FIFO, when an item is sold, it is automatically assumed that the oldest available item in stock is the one that has been sold. When inventory is managed well, this may be the case anyway, but this may not always be practical or possible. But making this assumption is important for calculating overall profit on a product line, taking into account variations in wholesale prices from one order to the next.

A typical FIFO inventory calculation

An e-commerce clothing retailer sells winter coats, and has bought in some stock through the summer months to prepare for an expected peak in the autumn. In June, they buy 40 coats at a wholesale price of £50 each. But as demand for retail stock increases, the supplier increases their prices. The retailer has to pay £70 per coat for the 40 coats they order in July, and £90 per coat for the next batch of 40 in August.

By the end of September, 60 coats have been sold by the retailer. For the purposes of the FIFO calculation, those are the 40 coats from the June order and 20 of the coats from the July order. This means the remaining inventory value stands at:

• 20 coats from the July order at £70 each = £1400
• 40 coats from the August order at £90 each = £3600

This comes to a total of £5000, which is the value of the inventory that the retailer has in stock at that time.

In turn, the retailer is also able to calculate their Cost Of Goods Sold (COGS) at £3400:

• 40 coats from the June order at £50 each = £2000
• 20 coats from the July order at £70 each = £1400

Why is FIFO Inventory Management Important?

You may think that it doesn’t matter which order your stock gets sold in, as long as it gets sold. But there are a lot of very good reasons to adhere to the FIFO inventory method – not only for the stock itself, but for your business as a whole:

Maximising value of perishable items

Just like that bread and milk we mentioned at the top of this guide, some items are perishable and will degrade in quality or saleability over time. This doesn’t just apply to consumables like food: for example, fashion items could quickly lose their appeal as styles and trends change or beauty products could expire. The FIFO method maximises the sale and profit potential of every item, and minimises the risk of anything sitting around unsold for too long.

Meeting compliance requirements

Your business will be required to compile and submit financial reports, and these have to be done in particular ways that align with ‘Generally Accepted Accounting Principles’ (GAAP) and/or International Financial Reporting Standards (IFRS). The FIFO method is allowed within GAAP and IFRS as a way of valuing inventory levels for reporting purposes, and is a relatively straightforward way of meeting this important compliance demand.

Valuations, cost analysis and forecasting

Understanding the value of inventory that your business has at any one time is vital for making informed decisions in the future. Knowing that you have a lot of investment tied up in stock may prompt you to reduce the amount of stock you order next time around. There are also tax implications around your FIFO-based inventory value (which we’ll cover later on in this guide) that may also influence your planning and strategic direction.

How Is The FIFO System Beneficial for E-Commerce Businesses?

Successfully implementing the FIFO method isn’t just a good way of maximising the profitability of your stock – it can generate meaningful change across the rest of your e-commerce operation, too:

Lower inventory costs

By moving goods on in the order that you receive them, the time that each item spends in your storage or warehouse facilities is kept to a minimum. This reduces the risk of items soaking up valuable space (and costs) by sitting in storage for long periods of time. The knock-on effect is that the level of stock can be held at a relatively consistent level over time, which can help maximise the efficiency of storage costs and associated overheads.

Faster turnover and cashflow

Connected to the previous point, being able to turn over stock quickly means that there will be more regular cashflow coming into the business, without too much funding being tied up in stock for too long. This can give your e-commerce operation much-needed flexibility, either to cover important costs such as tax bills, or to reinvest in other stock and product lines as needed without relying on loans or credit.

Smoother warehouse operations

FIFO can make things simpler in practical inventory terms, too. The amount of resource and effort needed to manage stock is reduced, as the need to move stock around to keep the warehouse organised can be greatly reduced. It becomes much clearer which stock came in when, and which stock should be sold next, and this can generate some substantial efficiencies, especially if you have large product ranges and stock levels.

More efficient supply chain

All of the first three points come together to enable a much more efficient and organised supply chain. The movement of goods from supplier to retailer to customer can be made much more reliable and consistent. Furthermore, the ability to make more regular and consistent orders from suppliers can open up opportunities for more preferential rates and stronger supplier relationships.

Complements seasonal fluctuations

Some retail sectors such as beauty, fashion and jewellery are subject to major peaks and troughs in demand through the year. For example, winter coats (as we mentioned above) sell well in the early autumn, while jewellery sales tend to be strong through the winter, thanks to Black Friday, Christmas, Chinese New Year and Valentine’s Day.

Scalable as your business grows

FIFO can be applied to any size of product range or inventory, big or small. This is good news if you have growth and expansion ambitions for the future, as you can easily scale up your inventory system without the need for a costly or expensive overhaul.

Greater customer satisfaction

Depending on the type of goods you’re selling, the FIFO method can make a real difference to customer satisfaction. Sending your customers products that are new and fresh helps you meet their expectations and improve customer satisfaction with your brand, particularly when items are perishable or subject to changing trends.

What Should I Be Aware Of When Using the FIFO Method?

FIFO inventory management doesn’t come without its challenges, especially from a financial and accounting perspective. From our experience working with e-commerce operations that use FIFO, you should especially watch out for:

Potential for higher income taxes

When you submit your financial reports, you’ll need to state your COGS figures, so that your profit can be calculated accurately and taxed accordingly. If you’re selling older stock acquired for lower wholesale prices, and are therefore generating higher profit margins when those items are sold, then you may find yourself paying higher taxes several months later.

Price fluctuations affecting profitability and tracking

FIFO can become complicated when the items involved are relatively price-volatile, i.e. the wholesale prices you pay, and the retail prices you sell them for, are subject to substantial and/or regular changes. Keeping track of which items were ordered, how much was paid for them, when they were sold and how much profit they generated can be much more difficult. If you’re running a small e-commerce operation, this can take up a lot of valuable time.

Proactive inventory management is a must

The best way to keep on top of inventory is to record all relevant information at the earliest opportunity. You should store key data like purchase price, quantities and any related purchase orders as soon as the goods are received (or if not immediately, later that same day). Otherwise, you risk an administrative minefield later on, as you try to match up stock to invoices and purchase orders, and work out which figures apply to which items – some of which you may already have sold.

Look for external expertise if you need help

While the principles behind FIFO are very simple, the administration of it can be time-consuming and complicated – especially if you’re running an e-commerce operation with lots of other things to take care of day-to-day. This is where the expertise of a third-party logistics (3PL) provider can be invaluable. Outsourcing your fulfilment to a 3PL partner means they can help you to manage  your inventory, apply FIFO comprehensively and rigorously, and ensure the approach works perfectly for your business – not only from a stock perspective, but from an accounting perspective, too.

FAQs

Do items always have to be shipped in the order they’re received?

Not necessarily, no. The application of FIFO for inventory management can be different and separate from applying FIFO for accounting. But if you’re running an e-commerce operation, it can make sense to do both at the same time, because it makes admin and tracking much simpler. If working with a third-party logistics provider, they’ll be able to advise on the best strategy for your business.

What do warehouse staff need to know about working with FIFO?

The fundamental bedrock that makes FIFO work is data: the what, when, where and how much of every single item you procure. Employees need to know that recording and tracking these key facts should be done constantly and meticulously, and that when picking and packing, they should check which stock they’re sending out very carefully. Of course, if a 3PL provider is managing your fulfilment, they will have experienced professional staff who will be able to take care of the whole fulfilment process for you.