FIFO Method (First-In, First-Out): Definition & Examples

Understanding how your business tracks inventory costs can significantly impact profitability, taxes, and financial clarity. One of the most common and simplest inventory valuation methods is FIFO, short for First-In, First-Out. This approach assumes that the first items purchased or produced are the first ones sold, used, or removed from inventory.

In this article, we explore what FIFO means, how it works, and why it matters for your small business accounting and tax strategy in 2026.

Key Highlights

• The FIFO method assumes the oldest inventory costs are recorded as sold first.

• FIFO is accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) accounting standards.

• It provides a clearer, more intuitive picture of inventory flow for small businesses.

• Using the FIFO method can impact the cost of goods sold (COGS), taxable income, and reported profit.

• Small business owners can easily implement FIFO through proper bookkeeping and accounting systems.

• 1-800Accountant’s experts can help set up the optimal inventory valuation approach for your business.

What Is the FIFO Method?

Definition of FIFO

FIFO stands for First-In, First-Out. It’s an inventory valuation and cost-flow assumption used in accounting to determine how costs are assigned to inventory and sold goods. Under this method, the oldest costs are expensed first, while newer inventory costs remain on the balance sheet as assets.

In other words, when you record COGS, you assume that the first items added to your remaining inventory are the first ones removed, whether by:

• Sale

• Usage

• Disposal

FIFO is widely accepted under both U.S. GAAP and IFRS, making it a flexible option for businesses of all sizes.

Why Small Businesses Should Care

Inventory accounting isn’t just for large retailers. Even small businesses, from Etsy sellers to construction firms, track supplies, materials, or products that count as inventory. The method you choose affects:

• COGS

• Gross profit and taxable income

• Inventory value on the balance sheet

Because FIFO reflects natural stock movement and current costs, it’s often the simplest and most intuitive option. It’s especially valuable for businesses managing perishable goods or items that can quickly lose value.

Accurate inventory valuation can also impact loan applications, investor reviews, and pricing decisions. Partnering with a professional firm like 1-800Accountant ensures your bookkeeping and inventory accounting requirements are set up to support accurate reporting and tax efficiency throughout the year.

How FIFO Works: Step-by-Step and Examples

The Cost Flow Mechanism

Under FIFO, the cost of your oldest inventory is assigned to COGS when you make a sale. The newest inventory costs remain in your ending inventory balance.

Even if your physical flow differs, for example, you sell newer products first, the accounting assumption remains consistent: the first goods in are the first to go out. This is important because accounting focuses on the FIFO cost flow assumption, not necessarily the physical flow.

Numerical Example

Let’s look at a basic illustration:

Step 1: Determine which costs apply to the 150 units sold.
Under the FIFO accounting method, the first 100 units from the $10 batch are sold first, followed by 50 units from the $12 batch.

COGS Calculation:(100 × $10) + (50 × $12) = $1,600

Step 2: Determine ending inventory.50 units remain from the $12 batch.

Ending Inventory Value:50 × $12 = $600

This method leaves newer costs in inventory and applies older costs to sales, producing a higher ending inventory value when prices are rising.

Real-World Application for Small Business

Imagine a small e-commerce business selling handmade candles. If wax and packaging costs rise throughout the year, FIFO means your earlier, cheaper stock is recorded as sold first. This leads to a higher inventory value on your balance sheet and potentially higher taxable income.

To apply FIFO effectively:

• Track purchase dates and quantities.

• Use inventory software that supports FIFO layering.

• Regularly update your records to reflect accurate stock movement.

This is how FIFO works for small businesses like yours, or can. 

Why Use FIFO? Key Benefits

Review the key benefits of using the First-In, First-Out inventory method. 

Advantages for Inventory Management

• Prioritizes older stock to reduce waste and obsolescence.

• Aligns with natural product flow, particularly for perishable or time-sensitive goods.

• Makes physical inventory organization more intuitive.

Financial and Accounting Advantages

• The ending inventory on your balance sheet reflects recent costs, providing a more accurate snapshot of current value.

• Since COGS is based on older (often lower) costs, gross margins appear higher during inflationary periods.

• Produces cleaner, more consistent financial reporting, which is beneficial for lenders, investors, and tax planning purposes.

Why It’s Especially Relevant for Small Business Owners

Small business owners benefit from the simplicity of FIFO. FIFO is:

• Easy to implement and widely supported by accounting software.

• Transparent for loans, forecasting, and tax preparation.

• Reliable for making pricing and purchasing decisions.

For deeper insight into how FIFO connects to your business’s assets, liabilities, and equity, a professional accountant can walk through how each element interacts in your financial statements.

Limitations and When FIFO May Not Be Ideal

Challenges with Cost-Matching and Inflation

When prices rise, FIFO assigns lower historical costs to COGS, which can inflate profits and increase taxable income. This may create a mismatch between today’s selling prices and yesterday’s costs.

Operational and Industry Limitations

FIFO isn’t perfect for every business. If your company has slow inventory turnover, fluctuating material costs, or specialized products (like jewelry or custom machinery), FIFO may not mirror actual cost flow accurately.

Compliance and Reporting Considerations

• The FIFO inventory valuation method is required in many international frameworks since IFRS prohibits LIFO.

• Once adopted, businesses must use the same inventory method consistently each year.

• Accounting standards require disclosure of the chosen method in financial statements.

FIFO vs. Alternatives

FIFO vs. LIFO

LIFO (Last-In, First-Out) assumes the most recent inventory is sold first. Under rising costs:

• FIFO results in lower COGS and higher ending inventory.

• LIFO results in higher COGS and lower ending inventory.

While the LIFO method can reduce taxable income in inflationary periods, it’s not permitted under IFRS, limiting its use internationally.

FIFO vs Weighted Average and Specific Identification

For most small businesses, the FIFO method remains the simplest and most practical option.

• Weighted Average Cost: Smooths out price fluctuations by averaging costs across all units.

• Specific Identification: Tracks the exact cost of each item, which is ideal for high-value or unique goods.

How to Choose the Right Method for Your Business 

When selecting the right method for your small business, consider:

• Price volatility

• Inventory turnover

• Tax implications

• Industry norms and compliance rules

Consulting an accountant helps ensure your chosen method supports your financial goals. The advisors at 1-800Accountant can help determine which valuation method best fits your business structure and reporting needs.

Implementation Tips for Small Business Owners

Review these FIFO implementation tips to ensure the best possible outcome for your business operations. 

Setting Up Accounting and Record-Keeping

• Track inventory purchases by date, unit cost, and batch.

• Use bookkeeping software with FIFO capabilities.

• Regularly reconcile inventory and COGS to avoid discrepancies.

Monitoring and Reviewing Inventory Layers

• Periodically review cost layers and stock aging reports to ensure optimal inventory management.

• Organize storage areas so older goods are used or shipped first.

• Utilize SKU tagging to align physical and accounting processes.

Tax and Financial Statement Considerations

• Understand how FIFO impacts your taxable income and reported profit.

• Review disclosures in your annual financial statements.

• Reassess periodically if cost trends or inventory composition change.

Common Pitfalls and How to Avoid Them

• Confusing physical inventory flow with accounting flow.

• Failing to adjust for cost fluctuations in records.

• Neglecting to coordinate with your accountant on tax implications.

Frequently Asked Questions (FAQs)

What types of businesses should use FIFO?

Retailers, manufacturers, e-commerce sellers, and service businesses with materials or supplies can all benefit from FIFO. It's not a perfect fit for every small business, but many benefit from the insights it provides. 

Can I switch from FIFO to another method? What are the implications?

Yes, you can switch from FIFO to another method. However, you’ll need IRS approval and must adjust prior statements to reflect the change.

Does FIFO matter if my costs are stable?

Even when prices don’t fluctuate, FIFO provides a consistent method for tracking and valuing inventory.

How does FIFO affect taxes?

During inflationary periods, the FIFO method can increase taxable income, as older, lower-cost items are recorded as expenses.

Is FIFO required by the IRS or other regulatory bodies?

No, FIFO isn't required by the IRS and other regulatory bodies. However, it’s permitted under IRS rules and commonly used in small business accounting.

Conclusion: Why FIFO Matters and Next Steps

Choosing the best inventory valuation method for your small business operations is more than an accounting decision. It directly impacts:

• Profitability

• Tax obligations

• Financial clarity

The FIFO method offers transparency, simplicity, and accuracy, making it a trusted choice for many small businesses.

At 1-800Accountant, America's leading virtual accounting firm, our team of experienced CPAs, EAs, bookkeepers, and tax professionals helps small business owners align their accounting methods with their financial goals. From bookkeeping to tax planning, we provide personalized guidance, allowing you to focus on what you do best: building your business.

Schedule a free 30-minute consultation today to review your inventory accounting and ensure your method supports your business’s long-term success.