Managing inventory and assets is among one of the most important tasks to do properly when it comes to business. After all, your inventory or assets are what you create or purchase to sell to customers. So, it only makes sense for you to carefully keep track of all these. As they are what will determine the profitability of your handmade business. There 8 reasons your handmade business should use FIFO, and we want to share them with you.
In order to do that right, you need to try and adapt your handmade business to one of the many inventory management methods that are out ther. A popular example of these inventory management methods is FIFO, or first in, first out. And LIFO, or last in, last out. In this article, you’ll learn the significance of the use of FIFO. As we at Inventora believe the fifo method of inventory valuation is the best method for handmade businesses, and businesses as a whole.
The Difference Between LIFO and FIFO Methods
FIFO and LIFO are the two most used and common inventory methods. FIFO stands for “first in, first out”. It assumes the first items entered into your inventory are the first ones you sell. LIFO, also known as “last in, first out”. This method assumes the most recent items entered into your inventory will be the ones to sell first.
When sales are on recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which is cheaper, would be sold later. With the inflation economy that exists, the current COGS would be higher under LIFO. This is because the new inventory would be more expensive. As a result, the company would record lower profits for the period. However, the reduced profit or earnings means the company would benefit from lower tax liability.
When sales are recorded using the FIFO method, the oldest inventory that is acquired first is used up first. FIFO leaves the newer and more expensive inventory, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old which was acquired for a lower cost is used to value COGS. However, the higher net income means the company would have a higher tax liability.
Is LIFO or FIFO Better for My Handmade Business?
Now that you understand the difference between FIFO and LIFO, both methods have pros and cons. Depending on your business’s needs, production methods and goals, you will need to evaluate which method is better suited for you.
For most handmade businesses, FIFO is the ideal method. FIFO is also more transparent and easier to use than LIFO. LIFO systems are easy to manipulate to make it look like your business is doing better than it actually is; meaning your results won’t always be a reliable source of your production and profitability. A FIFO system, on the other hand, provides a more accurate reflection of the current value of your inventory. With FIFO you are able to see truer numbers to what the value of your inventory actually stands for.
Even if your handmade business is just starting or still in the small stages, applying the FIFO method is the best option for matching actual practices to inventory accounting. This is why it is so important that you learn how to use and align it to your business. Also this is why you should select a method like this early on.
The importance of learning about this method, even though it seems to be a very simple one, is because once you put it into practice and you give your inventory accounting a turn, it can lead your business to have big positive changes in the cost of goods sold and net income. The FIFO method can be a huge cost reducer for your handmade business overtime. You may not see a large return overnight. However, over time you will notice a difference in the amount you’re saving by using this method.
What is FIFO?
In order to understand the reasons your handmade business should use FIFO, you need to learn what exactly FIFO is. Let’s talk about what the specifics of FIFO. What is FIFO? It’s important to fully understand the FIFO and LIFO methods before choosing which method is right for your business. Here are some key takeaways to have in mind and to have clarity in the understanding of what FIFO is.
FIFO stands for First in, first out.
FIFO is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first. The key takeaway purpose of FIFO is to use it as a tool to understand your COGS, or costs of goods sold. This is a calculation that absolutely essential to understand and have in your back pocket as a handmade business owner. This is what will allow you to determine better how much profits your business is actually acquiring. Without understanding this, you’ll not have a good precipitation of the success of your business.
FIFO assumes that the remaining inventory consists of items purchased last, as in your oldest items go out first.
This helps allow you to not have products that are expired or have become obsolete to your brand. This differs from LIFO, because LIFO is the most recent products in your inventory being grabbed first for purchases by your customers. This method is okay to use, however, it’s going to leave you with outdated products and old inventory. This could cause issues or problem for concern later.
The FIFO method assumes that the oldest products in a company’s inventory has been sold first.
The costs paid for those oldest products are the ones used in the calculation. This is why choosing a method is so important to understand the finances for your handmade business. The results from your calculation will not be the same for both FIFO and LIFO. So, once you pick a method, it’s important to stick to it. As it can be very difficult to change things around once you decide to begin.
Advantages of Using FIFO for Your Handmade Business
There are many advantages of using FIFO for your handmade business. We’ve broken down 8 reasons your handmade business should use FIFO. Additionally, we’ve broken down why the importance of FIFO in your handmade business can benefit your finances.
First and foremost, the FIFO method is easy to understand and universally accepted.
Not only does this make it easier on your brain when trying to figure calculations, but it’s a method that is in use most commonly. Therefore, when you’re considering an inventory management system to help you manage your business day-to-day, there’s going to be a high likelihood that the system you select already has implemented a FIFO function into the software. The simplicity of this method should be one of the top reasons your handmade business should use FIFO.
FIFO also comes quite in handy when prices increase or when inflation occurs.
You’ll receive high profit margins immediately with the FIFO method. The price of your older products will be lower than the price of the products you just created. Therefore, if you’re getting rid of older products first, you’ll be making more money back.
The FIFO method is simple to understand and easy to apply.
Anyone can do it! A responsibility that comes with being a handmade business owner is being able to keep up with the financial status of your business. A.K.A. doing math, a lot! Equations and numbers probably weren’t a part about your business journey that excited you. Therefore, you should always be searching for ways to streamline this process for your business. Make it simpler on yourself. An easy way of doing that, is choosing the most widely accepted formulas. You’ll thank us later!
The IRS and other regulatory boards prefer FIFO above other methods.
If you’re not sold on FIFO yet, you should be now! Think about how much of a headache doing your taxes can be… small business taxes are no joke! Take the liberty of selecting a method you know will be accepted. This will make tax season a little less of a burden on you. Whether you choose to do your taxes by yourself, or hire an accountant, this will help you streamline the process. Inventora can also help with this by assisting in organizing the needed documents you’ll need to have for tax season.
The first in, first out method also causes less waste.
You will be moving the oldest inventory first and using your supplies in an effective way. Allowing you to have more savings. This is such a simple way to save money. It may take time, but you will notice a difference of money saved each period when using the FIFO method. Those little costs can really add up over time. For more ways to reduce financial waste for your small business, click here.
Your unsold inventory better reflects what the costs are now. As opposed to what they were when the first items were purchased with FIFO.
This lowers the cost of goods sold, and again, is a cost reducer for you in the long game. It really is so important to save where and when you can when you’re first starting out. Make sure you’re taking advantage of the small moments where you are able to save a few bucks.
Because of inflation, businesses using the FIFO method are often able to report higher profit margins than companies using the LIFO method.
This is because the FIFO method matches older, lower-cost inventory items with higher current-cost revenue. Businesses on the LIFO system, on the other hand, see less of a margin between their current costs and their current revenue. Meaning, you’re possibly losing money when you choose to select the LIFO method.
FIFO also best matches your financial statements with your actual practices.
This is because you’re staying up to date with your materials and supplies. When you use and sell the items as they come in and are being sold, you’re being most efficient with your expenses and profits.
FIFO Inventory Practices
Inventora knows the best practices that benefit your business because we too are handmade business owners. We understand the importance of choosing FIFO and LIFO in inventory management. Co-founder Dianna Allen, founded Inventora because of her need to a useful inventory management system as a handmade candle business owner. Dianna and Jeremy have implemented the most useful practices into Inventora for handmade business owners because they understand what handmade business owner’s need. Inventora uses the FIFO accounting method for COGS calculation. Meaning, that we track which materials that are being received first to use. We do this because we know that’s what handmade makers need in their best inventory practices. Yet, another one of the reasons your handmade business should use FIFO.
We at Inventora understand that material prices may change each time you order them. As you enter new supply orders, Inventora makes sure that the material costs matches up with the order you have received and use them.
This is an example of how to calculate ending inventory using FIFO with Inventora…
Let’s say you order 20 candles jars for $4. Then you order 10 candle jars for $6. If you input into Inventora that you made 30 candles, our software will know 20 of those candles were $4 in material costs, and the other 10 were in a higher cost.
Pro tip: If you need help determining product prices for your handmade business, click here.
The matching principle is one of the accounting keys. This dictates that a business should report revenue or expenses in the same period that they are incurred. With the FIFO method, you can make this happen when accounting for inventory.
Improving Your Inventory with FIFO
The first in, first out method is an effective way to process inventory. As it keeps your stock fresh, with few to no items within your inventory becoming obsolete. The best part, is how the FIFO method is also an easy, transparent way to calculate your business’s cost of goods sold. In an inflationary economy, FIFO maximizes your profit margin and assigns the most current market value to your remaining inventory. That all means good things for your company’s bottom line.
We know that there are many methods similar to FIFO. You have a lot of options to choose from. However, we encourage you to select a method and stick to it. Avoid switching between methods based on how you want net income to look. This can cause complications in your accounting and add many questions about your business finances. This is also illegal. Under U.S. law you’re only allowed to switch once from FIFO or LIFO your the company’s history. So you should really heavily consider your options before you start. For now, learning the reasons your handmade business should use FIFO should help enable you to calculate profit more easily. And in addition, allow you to understand how much you’ll need to pay for your small business taxes.
To get a start on streamlining your inventory and get assistance in organizing your taxes, sign up with Inventora today! Join our Hobby plan for $0 down month. Or allow yourself access to more key operational features with our Business plan for only $19 a month. Sign up for the Inventora newsletter below for exclusive offers to our users and small business tips!
