FIFO (First In, First Out): What is it, Methods, and How Does It Work?

Introduction

Inventory is money sitting around in another form – Rhonda Adams, USA Today.

The First-In, First-Out (FIFO)  is a widely used method for inventory management at the end of any accounting period. Here, the oldest inventory items are sold or used first, and the most recent stock will be the last to be used or go for sale.

Efficient inventory management can significantly improve your business’s bottom line. The FIFO method helps by positioning the right stock in the right place at the right time.

FIFO calculates the cost of goods sold (COGS) based on the price of the earliest acquired items, thus enhancing your net income. It is exceptionally well suited for industries with perishable or time-sensitive goods, as it minimizes redundancy of products. 

The FIFO method is approved by accounting standards and compliant with accounting principles. 

FIFO full form

FIFO is an acronym. It stands for “First-in, First-out”. As the name suggests, the FIFO method is based on the concept that the goods arriving on the inventory shelves first will also be the first to come out on the market shelves.

What is FIFO inventory management?

Let us use the example of a bakery unit to understand the concept of FIFO.

Let’s say you have 100kg of flour in stock, which was delivered in January at Rs.40 per kg, and have another 100kg delivered in February at Rs.42 per kg. Following the FIFO method, when you make bread in March, you will first use flour from the January stock. The January stock of flour will be the first to be used up from your inventory account. 

The remaining flour in inventory will be accounted for at the most recently incurred costs. Subsequently, the inventory asset on the balance sheet will show expenses closer to the current prices in the marketplace.

Using the January flour for making and selling the bread in March boils down to matching older historical costs to current revenues. In an inflationary environment, this will result in a higher cost of goods sold (COGS) and the highest possible gross margin. 

The example illustrates the FIFO inventory management. Let us go ahead and understand how FIFO works as an accounting method in inventory valuation.

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What is the FIFO method?

The FIFO method of inventory valuation is an accounting method based on a cost flow assumption that the first items purchased or produced are the first to be sold. In other words, FIFO defines how you would move the product cost  from inventory to the cost of goods sold (COGS).

The method reflects the actual inventory flow in many business operations. However, you may not always end up selling the oldest products first. It is not linked to physical inventory tracking but only to inventory totals. 

To calculate the COGS, FIFO uses the cost flow assumption that the oldest inventory will be sold first. 

COGS using the FIFO method = Cost of your oldest inventory X Amount of inventory sold

Specific inventory costs must be used for this calculation. You must consider the inventory price fluctuations, if any, during the period for which COGS is calculated. 

How does this calculation method help your business? We will explore the importance of using the FIFO method in managing and valuing your inventory.

Importance of the FIFO method

The health of your inventory management depends on knowing what items you have, what you sell, and what it’s all worth. The FIFO method can prove to be a critical tool in this assessment. 

The FIFO methodology is based on the sequential storage and usage of the purchased or produced inventory. It complies with the guiding principles of inventory management and is a relatively simple inventory costing method.

The importance of FIFO can prove to be multi-fold.

• It is the lifeline for businesses that deal with perishable goods like food, flowers, and drinks, to name a few. These goods must be consumed in their production order, or they will depreciate and be wasted.

• FIFO also ensures you do not waste resources on the older inventory. Customer satisfaction will be high as they receive the freshest stock possible. 

• FIFO plays an essential role in manufacturing processes. It ensures that each component is used in the proper sequence to produce the finished product.

• Businesses can have a good grip on inventory. It will prevent them from overstocking or understocking products, resulting in reduced storage area requirements and streamlined warehouse activities.

• Using FIFO will optimize inventory levels throughout the value chain. It will allow you to quickly identify discrepancies, adjust stock levels, and organize operations. 

• FIFO helps businesses ensure the correct attribution of value for the cost of goods sold (COGS) to pay their fair share of income taxes accurately.

By managing inventory efficiently, you could increase efficiency across the board. It will lead to higher customer satisfaction rates and ultimately increased profits. 

No matter what the size of your business is, FIFO can prove to be crucial. To make FIFO work for your business, it is best to have clarity on the salient features of this method. 

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Features of the FIFO method

The FIFO method is considered the theoretically correct inventory valuation method, as in most industries, the cost flow assumption coincides with the actual flow of products. It makes business sense to sell your older inventory first and reduce the risk of inventory obsolescence.

FIFO is widely used for calculating the cost of goods sold and closing stock.

What are the salient features of this methodology?

There are two main characteristics unique to FIFO which affect your business.

1. Ending inventory costs

The products first purchased are the first to be removed from the inventory account. Then, the current stock will be valued at the present-day market prices. It means that the remaining products in inventory will be attached to the most recently incurred costs. 

Therefore, the inventory asset recorded on the balance sheet will have costs closer to the recent prices in the market. This means the company’s current assets will have the recent appraised values. 

2. Cost of goods sold (COGS) calculation

The technique also uses the oldest available purchasing expenses to calculate the cost of items sold. It ties the older historical prices to current revenues. Consequently, the gross profit margin may reflect a mix of present income and historical costs.

FIFO will better approximate the ending inventory balance on the balance sheet when prices increase. However, it will generate a higher net income as inventory that may be several years old is used to value the cost of merchandise sold. 

Despite its popularity, you could encounter certain problems while adopting FIFO.

FIFO method problems and solutions

It is best to consider the issues that may arise by using the FIFO method and ways to avoid them. This can help mitigate the challenges associated with this methodology.

Probable Problems	Suggested Solutions
Higher income tax liability during inflation	Work with tax experts and implement proactive tax planning strategies to manage tax liabilities effectively during inflationary times.
Inaccurate profit recording	Automation can help provide real-time insights into different inventory valuation methods. Consider using the weighted average cost approach in tandem with FIFO.
Complex record-keeping	Implement automation in record-keeping processes to reduce the complexity of managing FIFO inventory flows.
Potential for higher holding costs due to overstocking	Regularly review inventory levels and optimize ordering quantities. Implement just-in-time inventory practices to minimize holding costs.
May not reflect the current market value	Regularly update inventory pricing based on market trends and demand fluctuations. Adjust pricing strategies accordingly.
Impact on profit margins	Monitor profit margins closely by considering gross and net margins. Adjust pricing strategies and operational costs to maintain profit margins.

With all the information we have about FIFO, let’s get to know how it works. 

How Does FIFO Work?

Inventory of your business is considered an asset. Subsequently, calculating the cost of goods sold (COGS) at the end of the accounting period or fiscal year is mandatory. The ending inventory value impacts your balance sheets and inventory write-offs. 

Typically, recent inventory is more expensive than older inventory due to inflation. An important point to understand is that FIFO is a methodology designed for inventory accounting. It provides a simple formula to calculate the ending inventory. 

In the FIFO methodology, the lower-value inventory is sold first; hence, the ending stock tends to be worth a higher value. Also, the inventory left over at the end of the financial year does not affect the COGS.

In many cases, the goods purchased or produced first may not necessarily be sold first. 

However, the benefits are twofold if you successfully implement FIFO in accounting and with the physical inventory. You can then achieve an ideal inventory management scenario where you calculate inventory value that matches the natural flow of inventory throughout the supply chain.  

FIFO will make tracking, regulating quality, and reducing holding costs for obsolete or non-sellable inventory possible. The downside of FIFO is that it can cause discrepancies during inflationary times. Profits will take a hit if product costs triple and accounting uses values from months or years ago. Also, unless prices decrease, there are no tax advantages.

The practical working of FIFO can be made clear by an example. 

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FIFO method example

We will consider an example to demonstrate the practical application of FIFO in a business.

XYZ-Clothing Retail Company Initial Purchase of 100 shirts at     ₹ 1000 Begining inventory                      ₹ 1,00,000   Let’s assume there is a need to increase inventory as the shirts get popular.   Second Purchase of 200 shirts at  ₹ 1250 Added inventory                           ₹ 2,50,000   Total inventory of 300 shirts        ₹ 3,50,000

Throughout the grand opening month of January, the store sold 90 of these shirts.

At the end of January, 

• COGS calculation using FIFO

90 shirts at ₹ 1000    = ₹ 90,000

Total COGS              = ₹ 90,000

• Inventory valuation 

Beginning inventory  – 90 shirts sold.

The remaining stocks are 210 shirts (10 – beginning inventory & 200 – second purchase).

Remaining inventory valuation using FIFO

10 shirts   @  ₹ 1000        =      ₹    10,000

200 shirts @  ₹ 1250        =      ₹ 2,50,000

Value of ending inventory =      ₹ 2,60,000

With the remaining 210 shirts, XYZ sells another 100 shirts.

At the end of February,

• The COGS will now be

10 shirts @  ₹ 1000 =  ₹   10,000

90 shirts @  ₹ 1250 = ₹ 1,12,500

Total COGS             = ₹ 1,22,500

• Inventory valuation

110 shirts @ ₹ 1250 = ₹ 1,37,500  

This example was from the fashion industry. The FIFO method is used and widely accepted across sectors and industries. 

FIFO in different industries

Whether you are in the business of producing medicines, selling soda, manufacturing a computer, or running a restaurant, FIFO is working behind the scenes. Across industries, companies arrange for their oldest inventory to be sold first. It ensures that their inventory and balance sheet match.

The FIFO method is the perfect choice for industries where the value of the products decreases with time. Well, that will be the case in most industries. 

The food, flowers, medicine, and cosmetic sectors are the most common. They typically manage perishable commodities with an expiry date. 

Day in and day out, the supermarket chains and hospitality industry, which includes restaurants, hotels, and catering businesses, rely on the FIFO stock management method for smooth operations. FIFO reduces losses, given that the inventory has a limited shelf-life in these industries. Conversely, if you assumed to sell the newest inventory first, you would constantly write off old stock as it perished.

Companies dealing with products that tend to become obsolete or “go out of style” relatively quickly use FIFO as a standard method. Footwear, textiles, and technology products, like mobile phones and computers, are examples that would come under this category. 

For example, you would come across end-of-season sales on garments or huge discounts on older models of electronics just before the launch of a new model. Companies adopt these strategies to help them follow FIFO by selling off the aggregated old products in inventory. 

FIFO is also effectively used in the following prominent sectors

• Manufacturing
• Automotive
• Construction
• Chemical industry
• Agriculture
• Warehouse management
• Waste management

By now you must be wondering how to implement FIFO for your business. Well, let’s find out. 

Read About: Last In, First Out (LIFO): How to Manage Inventory Cost With it?

Steps to implementing FIFO in inventory management

Proper Implementation of FIFO will allow your business to streamline processes. It will reduce material handling, storage space required, and even carrying costs. 

Steps to implement FIFO

Let’s look at practices and procedures that will help implement FIFO effectively.

1. Understand the method

The team should understand the working and benefits of FIFO. Training staff on these principles is vital. 

2. Establish clear procedures

Create and document standard operating procedures (SOPs). These procedures need to be followed consistently by the team. 

3. Label and organize inventory

Labeling each item in inventory with the SKU (stock keeping unit) code, purchase or production dates, and expiration date is critical.  Labeling will help operators identify misplaced or expired items. Organize the storage area such that older inventory is accessible and used before newer items.

4. Rotate stock

Restocking and picking may happen at the same time. 

The stock should be rotated periodically to keep the older inventory in the front storage area and the newer inventory behind it. 

5. Track inventory and monitor expiry dates

Tracking inventory will help you identify items to be used next. It will minimize wastage.

6. Review supplier agreements

Communicate with suppliers to ensure they deliver items with clear date labels and earliest expiration or production dates first.

7. Regular audits and adjustments

Conduct regular audits to ensure compliance with FIFO. In case of discrepancies, you may have to adjust inventory records. 

8. Compliance and Reporting

Your inventory records and financial reports should accurately reflect the implementation of the FIFO method. It is essential for compliance with accounting standards and regulations.

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Software

The FIFO method sounds excellent and can be a boon for your business. However, it is susceptible to costly mistakes due to human error. Inventory management software can make it simple and accurate. 

How can software help in the implementation of FIFO?

• Cloud-based software that offers a range of features to help you create workflows to track inventory levels and monitor stock movement. 

For example, you can add a barcode scanner to scan each received item. These details can be programmed into your workflow to be stored in the cloud. It is then easily accessible to monitor the stock at any point in time from anywhere. All you would need is an internet connection.

• Warehouse management software to track inventory and prioritize the oldest items first
• Accounting software in calculating the inventory of goods and the COGS

There are other inventory management methods available for you to consider. The other method contrasting to FIFO is the last-in-last-out (LIFO) method. 

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FIFO vs. LIFO: a comparative analysis

We will compare the two inventory management methods. The choice between FIFO and LIFO depends on factors such as industry norms, tax regulations, market conditions, and specific business requirements.

Aspect	First-in-First-Out (FIFO)	Last-in-First-Out (LIFO)
Order of inventory used first	Oldest inventory items are used first.	Most recent inventory items are used first.
Cost of goods sold (COGS)	Reflects current market prices, leading to lower COGS during inflation.	Reflects older, potentially lower purchase prices, leading to higher COGS during inflation.
Ending inventory value	Reflects current market higher prices, leading to higher ending inventory value during inflation.	Reflects older purchase prices, leading to lower ending inventory value during inflation.
Tax implications	Can lead to lower taxable income during inflation, leading to lower tax liability.	Can lead to higher taxable income during inflation, leading to higher tax liability.
Financial reporting	COGS represents the cost of older inventory items, reflecting the current profitability.	COGS may not accurately represent current market conditions, leading to distorted financial ratios.
Suitability	Suitable for industries handling perishable goods or products with limited shelf lives.	Suitable for industries with stable or falling prices, where older inventory is less likely to have significant cost variations.
Cash flow	As lower-cost items are sold first, it will typically result in better cash flow.	As higher-priced, newer items are sold first, it can result in lower cash flow.
Complexity	Easier to understand and implement, making it suitable for businesses with diverse products.	More complex to implement due to valuation adjustments, especially in businesses with frequently changing inventory.
Long-term impact	Provides a more accurate reflection of inventory value over a long period.	Can lead to inconsistencies in the inventory value shown on the balance sheet over time.

Each method has advantages and disadvantages, and you must consider all the above factors before selecting an inventory valuation method.

Quick Read: LIFO and FIFO Inventory Management: A Complete Guide

Advantages and Disadvantages of FIFO: A Balanced Perspective

“There is a flip side to every coin.”

Any system is bound to have pros and cons. The same goes with FIFO, too. Reviewing this inventory management system’s positive and negative aspects is best to understand the complete picture of FIFO.

Advantages of FIFO methodology

The most direct advantages are

• Reduced chances of obsolete products
• Perfect stock turnover
• Streamlined warehouse operations, Loading and unloading goods and stock handling will be done efficiently.
• Enhanced customer satisfaction, FIFO helps deliver consistent products within their expiry dates. It also guarantees the warranty on the products to be good. 

Furthermore, in the broader picture of your business, the following are the key benefits. 

1. Accurate cost representation

FIFO ensures that the COGS accurately reflects the current market prices by first using the oldest inventory’s cost. You can align your current business costs more precisely with the inventory outflow. It will help better accounting and a realistic picture of your business.

2. Automation compatible

Most accounting software is designed for the FIFO method. You can manage inventory costs efficiently by recording your most recent purchases or productions in the order they occur. It will help reduce possible human errors.

3. Accurate margins

In times of inflation, FIFO shows your actual gross and net profits. Precise COGS get plugged into your profit and loss statement, making financial reporting more accurate.

4. Attractive business

The difference between your current selling price and the cost you incurred with older inventory will set you up for increased profits compared to real-time inventory costs. Higher profits on your books will attract more investors or potential buyers. 

Disadvantages of FIFO

Let’s consider the other downsides besides the apparent disadvantages of old inventory perishing and increasing inventory storage costs.

1. Higher taxes during inflation

The FIFO method will generate higher profits during inflation. It becomes a happy problem as higher profits are tied to higher taxes.

2. Tough for volatile environment

The same goods may incur different costs during the matching period with fluctuating inventory prices. It may result in inaccurate profits recorded on your income statements. 

3. Complex record keeping

Managing the inventory flow and tracking different batches can be a big task if your business deals with many products. 

4. No physical match

The FIFO method does not necessarily match the physical inventory. The actual movement of goods in your business is not always as reflected in your accounting records. 

The pros of the FIFO method certainly outweigh the cons, making it a great method for inventory management in most businesses. However, every business is unique and has different needs. Considering the drawbacks before deciding if FIFO is the right fit for your business is essential. Also, FIFO can work better when best practices are consistently followed.

Practical Application and Best Practices

For the FIFO system to work efficiently for your business, it is essential to consider both the accounting and inventory management sides. Following best practices for both aspects is essential to manage your inventory well. These best practices will help get a good business cost analysis and enhance customer satisfaction. 

1. Inventory flow

To make your first inventory the first to be sold, look into how the new inventory flows into your system. It is especially true if you are in the perishable goods business, where the first in will also be the first to perish.

2. Accounting software

Using accounting software with an inventory management component embedded to support the FIFO method is vital. It will make your cost analysis much easier and more efficient.

3. Input inventory

It can be challenging to match inventory to purchase orders once it is loaded into the system and goes on sale. It is best to log the cost into your accounting system as and when you receive the inventory. The software system will make the appropriate price calculations. 

FIFO can be made to work very effectively for your business. However, there are certain misconceptions about the method for you to be aware of. 

Misconceptions about FIFO

Misconceptions can lead to confusion and create bias in decision-making. Clarifying them before deciding if FIFO will work for your business is best.Let us look at the few common misconceptions about FIFO and their clarifications.

Myth no 1: FIFO always gives the lowest COGS

Fact- While FIFO often leads to lower COGS during inflation, it need not be the case always. The actual COGS depends on the specific costs of inventory items at the time of sale.

Myth no. 2: FIFO always means selling the oldest physical item first

Fact – FIFO is a cost flow assumption. It assumes that the oldest inventory costs are used first for accounting purposes. In practice, it might not be emphasized in the actual sale of the physical inventory. 

Myth no.3: FIFO results in higher profits and better financial ratios

Fact – During inflationary times, FIFO can lead to higher reported profits. It affects the timing of recognizing profits but does not necessarily indicate financial performance.

Myth no.4: FIFO is the best for all businesses

Fact – The choice of inventory management method, including FIFO, depends on your specific business needs. Other factors to consider are industry norms, tax regulations, and cash flow requirements. What works for one business might not work for another.

Myth no.5: FIFO is always more precise and accurate

Fact – FIFO is a systematic method, but its accuracy depends on proper record-keeping and following set procedures. Errors in tracking inventory can lead to inaccurate FIFO calculations. 

Many major companies in the world have overcome the problems and misconceptions of FIFO to script success stories of inventory management by using the FIFO methodology. Huge businesses like Amazon, McDonald’s, and Walmart, to name a few, have used FIFO to their advantage. 

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Real-Life Success Stories: Triumphs with FIFO

Case studies are real-life examples of how the FIFO method has revolutionized inventory management for those companies. These stories showcase different ways to implement FIFO effectively in various industries. 

1. Case Study-XYZ Auto Parts

How FIFO Boosted Profit Margins by 15%?

1. Background

XYZ Auto Parts is a reputable supplier in the automotive industry. Inventory management proved challenging due to their diverse inventory and fluctuating market prices. The management implemented the FIFO method to optimize inventory turnover and boost profit margins.

2. Implementation of FIFO

XYZ Auto Parts revamped their inventory management system by executing the following.

• By integrating advanced software for real-time tracking of inventory levels
• Automating FIFO accounting calculations 
• Training staff to apply FIFO principles consistently
• Labeling and organized shelving

3. Impact on inventory management

Steps taken by XYZ yielded results. Over the next few months, it significantly reduced obsolete inventory. Older inventory was sold first, minimizing waste and ensuring products were utilized before expiry dates. Tracking of inventory levels helped XYZ optimize its stock levels. 

4. Boosting profit margins

XYZ‘s bottom line showed a remarkable surge. Accurate cost calculations and reduced waste translated into higher profitability for each sale. The FIFO method helped align their costs with revenue and surged their profit margins by an impressive 15%.

5. Operational efficiency

XYZ now has a streamlined inventory management system. They now experience improved operational efficiency across the company. XYZ has hugely benefitted by implementing the FIFO methodology. Going forward, they plan to leverage technology and data analytics to refine their inventory management strategies. 

6. Customer Satisfaction and Loyalty

Adopting FIFO enabled XYZ to fulfill orders promptly and precisely, resulting in customer satisfaction. Satisfied customers became loyal clients, ensuring a steady revenue stream for XYZ Auto Parts. 

XYZ Auto Parts optimized inventory turnover, freeing up capital for expansion.

Let us now consider the tangible impact of FIFO that XYZ will experience. 

1. Impact on cash flow

1.1 Reduced holding costs 

By selling older, lower-cost items first, XYZ minimized storage costs. Also, XYZ did not tie up excess capital by holding stocks. 

1.2 Faster inventory turnover

Products only stayed on the shelves for a short time. The faster turnover meant that XYZ didn’t need to maintain ample cash reserves to cover stagnant inventory. 

2. Resulting capital liberation

2.1 Working capital optimization

As XYZ sold the older items, the previously tied-up working capital was freed. XYZ could now redirect this freed capital to invest in marketing to explore new revenue streams. 

3. Opportunity for expansion

With the optimized working capital, XYZ Auto Parts has the financial flexibility to expand. They could venture into introducing new parts or opening new locations. The moral of the XYZ Auto Parts story is that not only did FIFO optimize cash flow, but it freed up capital previously tied up in stagnant inventory. 

The tangible effect of FIFO is that the freed-up capital helped XYZ expand and solidify its position in the market. Technology played a very big role in the success of the FIFO method at XYZ Auto Parts. 

Next, we will look at how technology can help you at every step of implementing FIFO. 

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Technology and FIFO Implementation

Technology plays a crucial role in effectively implementing FIFO. Technological advancements have revolutionized how businesses handle their inventory. 

Along with simplifying the complex inventory management process, it also

• Optimizes utilization of resources
• Reduces operational costs
• Ensures adherence to FIFO principles consistently

Here are a few ways technology can help you implement FIFO efficiently.

1. Automated tracking and monitoring

Advanced software and inventory management systems are available to record the entry and exit of goods. It meticulously records the purchase dates, quantities, and costs. You could perfectly align your inventory with the FIFO method by automatically flagging the older inventory for sale before the newer items. 

2. Barcoding and RFID (Radio-Frequency Identification) technology

Each product can be assigned a unique barcode or RFID tag for easy scanning and identification. In the context of FIFO, this technology helps precisely track the chronological order of items, ensuring that the oldest articles are utilized first.

3. Data Analytics and Predictive Algorithms

Modern inventory management systems can forecast demand patterns by leveraging data analytics and predictive algorithms. These patterns can predict which products are likely to be sold first. You can decide which inventory items to prioritize, reducing the risk of obsolescence and waste. 

4. Integration with supply chain partners

Electronic data interchange (EDI) and online platforms help businesses to share real-time information on inventory levels, deliveries, and sales. This connectivity ensures a smooth flow of goods in the supply chain even while dealing with multiple partners and locations. 

5. Mobile applications and cloud computing

Mobile applications and cloud-based inventory systems can provide on-the-go access to your inventory data. Cloud computing synchronizes data in real-time across multiple devices and locations. Personnel can use smartphones and tablets to monitor inventory levels and place orders regardless of the physical location of the inventory.

6. Technology in financial reporting

Automated accounting systems help eliminate manual errors in calculations and data entry. It helps generate precise financial statements crucial for compliance with accounting standards and regulatory requirements. 

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Conclusion

The FIFO method can be an effective method for your inventory management system. When choosing the right inventory management system for your business, it is important to consider the type of products being stored and the impact on financial statements, among other factors. 

FIFO especially works if you are in the business of perishable items with expiration dates or bulk quantities of non-perishable items without expiration dates. FIFO can offer numerous benefits to your business, such as enhanced customer satisfaction, reduced costs, reduced wastage, and increased efficiency. 

To maximize the advantages of FIFO, businesses need to set clear goals and objectives for inventory control. Training staff and integrating technology to automate the FIFO system will be pivotal in optimizing the benefits of FIFO.

Ultimately, the FIFO method is a great way to manage inventory and ensure goods are sold on time. 

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