Like it or not, inventory management is critical to managing your eCommerce business. Smart inventory planning can make a big difference in your cash flow and profit margins. So, understanding the concept of FIFO (first in, first out) is essential. The FIFO method can help you more accurately account for your cost of goods sold (COGS). It may also help reduce your eCommerce fulfillment costs.
What is first in, first out (FIFO)?
First in, first out inventory management is precisely what it sounds like: The first stock purchased/received is the first stock to leave. However, FIFO works slightly differently in accounting and order fulfillment.
FIFO in cost of goods sold accounting
For accounting purposes, FIFO assumes that the first raw materials you bought are the first ones you manufacture your product with, and that matters because your material costs can fluctuate over time. According to Red Stag Fulfillment Financial Analyst Mitchell Arnold, the question that FIFO accounting should answer is, “How do you allocate material cost when that cost fluctuates?”
At the end of the year, you’ll need to account for your cost of goods sold by subtracting the items you had in stock at the beginning of the year from your year-end inventory. However, the materials you bought in January might have had a smaller price tag than the ones you got in December. Using the FIFO method to account for your COGS is a clean and simple way to track your inventory flow.
The FIFO method in warehousing and fulfillment
You have probably seen the FIFO method in practice at your local grocery store. When a grocery employee restocks perishable foods, they put the newest inventory items on the back of the shelf and the oldest inventory in the front. That makes it more likely that all the stock will be sold before the expiration dates so that the store won’t lose money and food won’t spoil.
In an eCommerce fulfillment center, businesses that use a FIFO model for physical inventory flow rotate incoming inventory. Stockers place newer items at the back of the shelf and move the older ones to the front. When a customer places an order, the picker will pick the older stock from the front of the shelf, so inventory moves out in roughly the same order in which the warehouse received it.
How to calculate the cost of goods sold using FIFO
The best way to understand the FIFO approach to inventory is with an example. Let’s take the case of the Garden Gnome, an online retailer of gardening supplies and equipment. In January, the Garden Gnome ordered 50 trowels at a wholesale price of $10 each. The store sold 25 trowels in January, then ordered 75 more in February. For the second quarter, the wholesale price had gone up to $11. By the end of the first quarter, the eCommerce company had sold 75 trowels and had 25 still in stock.
Using FIFO accounting, the COGS of the remaining trowels is $11 each, or $275. The calculation for the COGS of the inventory that sold looks like this:
(50 x $10) + (25 x $11) = $775
As prices fluctuate throughout the year, FIFO inventory accounting will help the Garden Gnome keep track of its actual cost of goods sold. That helps it set appropriate retail prices. Also, the store uses FIFO warehouse management. That reduces the chance of getting stuck with outdated stock if a manufacturer changes a product style.
The “bullwhip effect” and FIFO cost flow assumption
In an ideal world, demand is steady and your supply chain moves at a predictable pace, producing goods just when needed. Of course, after two years of supply chain disruptions, it’s abundantly clear that we don’t live in a perfect world.
Consumer demand can spike or change, causing what Arnold calls the “bullwhip effect.” Instead of a straight line of products being pulled toward the end consumer, your supply chain gets distorted, like cracking a bullwhip. These distortions ripple through fulfillment, transportation, and manufacturing.
The cost flow assumption built into FIFO is that you’ll sell older goods first. When you experience the bullwhip effect, that cost flow assumption may get complicated, particularly if older merchandise becomes unsalable because of changes in consumer preferences.
“The objective of any retailer, manufacturer, anyone in the supply chain, is to make the bullwhip effect as smooth as possible,” Arnold says. He notes that some amount of bullwhip may be unavoidable at times, or for certain industries, but improving your demand forecasting is an excellent way to reduce this disruptive phenomenon.
Another approach to inventory management: last in, first out (LIFO)
Another way to handle inventory is LIFO, or last in, first out. In the LIFO model, newer items are placed at the front of the shelf and picked first. Arnold points out that there are sometimes good reasons to use a LIFO model for fulfillment. For example, an electronics manufacturer might want customers to get the newest version of a device, even if that means the older stock has to sell at a discount.
“Clients who choose a LIFO model have to reassess their old inventory,” he notes, and periodically mark it down or otherwise clear it out.
Using the LIFO method for inventory accounting usually assigns a higher value to the cost of goods sold than FIFO. That’s because the last items purchased may have higher prices (though sometimes the reverse is sometimes true). LIFO may lower your taxable income, but it will also make your P&L statement look less favorable. Showing higher inventory costs will decrease your profits.
It’s okay to mix and match FIFO and LIFO. For instance, some businesses use a LIFO model for fulfillment but the FIFO method for inventory accounting.
A critical goal of inventory management is to avoid incurring storage fees for dead stock that you can’t sell. Whether you pick and pack orders from the newest stock (LIFO) or the oldest (FIFO), it’s essential to optimize inventory levels.
Choosing between FIFO and LIFO for inventory management
“FIFO or LIFO is always trying to optimize costs or movement of goods,” Arnold says. You should use whichever method works best for your business.
Advantages of FIFO include:
- Tracks changes in wholesale pricing
- Increases the chances that products will fill orders before they become obsolete or go out of style
- Provides a straightforward method for ongoing inventory tracking and accounting
Advantages of LIFO include:
- Increases the amount you can deduct for inventory costs
- Ensures that customers get the latest product model at the time of their order
Of course, the disadvantage of LIFO is that you could end up with unsalable stock or products that have to be put on sale. If you sell items with a defined shelf life, FIFO is your business’s only workable inventory method.
How FIFO affects long-term storage costs
“Inventory that has not been produced in a timely manner to satisfy demand is an improper use of funds,” Arnold says. “On the macroeconomic level, in the grand scheme of things, dollars should be deployed where they’re actually generating value.” He notes that companies holding too much stock are “penalizing themselves by not deploying that capital elsewhere.”
Failing to rotate and turn over inventory can also hurt your bottom line by increasing your storage costs. Some 3PLs charge higher rates for stock that stays on the shelf for more than 180 days, or more than 365 days, as an incentive to help clients optimize inventory and storage.
For example, if the Garden Gnome online store has 50 trowels in stock and has sold a total of 150 over six months, it wouldn’t incur long-term storage fees. That’s true even if it uses the LIFO method and a few of those trowels have been at the back of the shelf for a long time. On the other hand, if Garden Gnome only sold 30 trowels in 180 days, its 3PL might charge a long-term storage fee on the 20 extra trowels on hand. Plus, that excess stock could be a sign that the online garden shop should keep no more than (and maybe less than) 30 trowels in inventory.
Red Stag Fulfillment helps eCommerce companies keep storage costs low
Inventory management is complex, and getting it right is essential to building your thriving eCommerce business. When you choose Red Stag Fulfillment as your 3PL, you add experienced professionals to your team. We can help you determine optimal inventory levels, add visibility to your supply chain to improve operations and keep your storage costs as low as possible.
At Red Stag Fulfillment, we know firsthand that top-notch fulfillment can help eCommerce companies grow and scale. We’ve seen it happen for our clients. We provide worry-free warehousing and fulfillment, so you can focus on expanding your business. We’d like to tell you how it works.
More about inventory management:
- Why Is Inventory Management Important in Everything You Do?
- Inventory Planning and Control: Tackling a $1.8 Trillion Problem
- Create Your Inventory Management Plan