Wax melt company Teddy Eva spends thousands of pounds at a time on soy wax, essential oils and containers for its products. The price of essential oils has increased enormously over the last year, following poor harvests in some parts of the world. The company uses a method of accounting called "FIFO" to allow it to calculate the cost of goods sold (COGS) with more accurate pricing data, better reflecting the changing prices of materials.
“Keeping track of costs is important because we are a young business, and inventory is probably our biggest expense because we want to invest in premium materials,” says Ross Hunt, Teddy Eva's managing director. “In other areas, we might try to keep costs very lean, like using TikTok for marketing or using recycled packaging. But when it comes to scents, oils and wax, we need to keep the quality as high as possible.”
What is the FIFO method?
If your business handles physical stock, then you probably use FIFO accounting to track the value of your inventory and to calculate COGS. FIFO stands for First In First Out and is an accounting method that assumes your business sells stock in the same order it was purchased.
FIFO vs LIFO
Businesses will usually organise their accounts using FIFO or LIFO, which stands for Last In, First Out. “FIFO is much more common than LIFO because it’s easier to understand, and is often required by generally accepted accounting principles,” says Clare Bowen, an accountant and director with business advisory firm Monahans.
LIFO is less commonly used and can sometimes provide a less clear view of a company’s financial position, adds Bowen. A business that sells a product that increases rapidly and significantly in price might adopt LIFO accounting, however, because the value of the product at the point of sale might be higher than the price assumed at the point when the inventory was purchased.
Example of FIFO
Building Company A buys 1,000 steel bars at £5 per bar. They then buy another 1,000 bars at a higher price of £10 per bar. This means the company has invested a total of £5,000 + £10,000 on inventory.
1,000 x £5 + 1,000 x £10 = £15,000
Over the quarter, the company sells 1,200 steel bars, leaving 800 bars in inventory. FIFO assumes that the company sold the 1,000 less expensive bars first, followed by 200 of the more expensive bars.
This information can be used in two ways, explains Bowen. First, we know the value of the inventory is £8,000 rather than £5,000 because the less expensive goods were sold first. Second, the company can use this cost of inventory to calculate COGS over time.
Advantages of FIFO
The key advantage of FIFO is that it is relatively simple to understand. “If you’re in the supermarket and you want to buy a ready meal, the supermarket will put the oldest product with the shortest use-by date at the front of the shelf because it wants that to sell first,” says Bowen.
Most commercial accounting platforms will use FIFO without the business needing to track physical inventory and sales. Teddy Eva uses QuickBooks for accounting and FIFO is applied as a default setting within the software. “I don’t need to worry about it, because the software allocates the right expenses to the right sales automatically, and adjusts our assets accordingly,” says Ross Hunt, the company’s managing director. “We are making a product that does use raw materials with prices that fluctuate, so it’s important for us to know the value of the stock we hold and ensure that we keep an eye on the cost of goods, and ultimately profit margins.”
Companies that use the FIFO inventory method in markets where prices tend to rise over time will look more profitable in the short term. That’s because your COGS calculations assume the lowest purchase price for inventory, meaning the profit margin is bigger. Using the American Express® Business Gold Card with its extended payment terms of up to 54 days, businesses have the flexibility in their cash flow to invest in inventory when pricing is best¹.
Businesses that adopt FIFO accounting can also benefit from more regular buying cycles by applying FIFO principles to physical stock. This is particularly helpful with goods that have an expiry date or where value is tied to when goods are sold, such as seasonal clothing or décor.
Disadvantages of FIFO
The main disadvantage of FIFO is that during a period of price rises, the value of a company’s inventory might be overstated. This is especially concerning if the inventory doesn’t have high liquidity, and cannot be easily converted into cash, says Bowen.
“FIFO can potentially give a misleading impression of a company’s position,” she says.
Who should use the first in, first out method?
Bowen’s advice is that most companies holding physical stock should use FIFO, especially if there is a ‘use by’ date that makes it helpful to ensure old stock is sold first. FIFO is less suitable for companies that sell both new and old products – for example, suppliers of microchips or other components.
There are also specific scenarios where FIFO accounting might not be suitable. Bowen gives the example of a business that is buying inventory that is rapidly – and substantially – increasing in price, such as a fuel garage or a diamond retailer. “If you buy a diamond at £1,000 and it very quickly increases in value to £2,000 without you doing anything, then you might choose LIFO, because it more accurately reflects the value of your inventory,” she says.
How to use FIFO
You can easily use accounting software and spreadsheets to apply the FIFO method for you as part of assessing your company’s assets and cost of goods.
When prices are rising rapidly - be it for diamonds, essential oils, or whatever your product is - then using FIFO with the COGS formula will produce a lower cost and higher gross profit than other accounting methods.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
