FIFO vs LIFO: Which Inventory Method Is Right for You?

When a company sells a product, it needs to know the cost of that product to calculate gross profit. But if it bought the same product at different prices over the year, which cost does it use? This is the inventory costing problem, and your answer has real consequences for taxes, reported profit, and balance sheet values.

Why Inventory Costing Matters

Consider a retailer that purchased 100 units of a product at three different prices:

• January: 30 units at $10 each = $300
• April: 40 units at $12 each = $480
• September: 30 units at $15 each = $450

Total cost of 100 units: $1,230. Average cost per unit: $12.30.

Now the company sells 60 units. What is the cost of goods sold (COGS)? That depends entirely on which inventory assumption you use.

FIFO: First-In, First-Out

Under FIFO, the oldest inventory is assumed to be sold first. It doesn't matter whether this matches the physical flow of goods — it's purely an accounting assumption.

COGS calculation (60 units sold):

• First 30 units from January batch: 30 × $10 = $300
• Next 30 units from April batch: 30 × $12 = $360
• Total COGS: $660

Ending inventory (40 units remaining):

• 10 units left from April batch: 10 × $12 = $120
• 30 units from September batch: 30 × $15 = $450
• Ending inventory: $570

Under FIFO, the balance sheet carries inventory at more recent (higher) costs, and COGS reflects older (lower) costs.

LIFO: Last-In, First-Out

Under LIFO, the most recently purchased inventory is assumed to be sold first. This method is allowed under U.S. GAAP but prohibited under IFRS.

COGS calculation (60 units sold):

• First 30 units from September batch: 30 × $15 = $450
• Next 30 units from April batch: 30 × $12 = $360
• Total COGS: $810

Ending inventory (40 units remaining):

• 10 units from April batch: 10 × $12 = $120
• 30 units from January batch: 30 × $10 = $300
• Ending inventory: $420

Under LIFO, COGS is higher and ending inventory is lower — the balance sheet understates inventory value in a rising-price environment.

Side-by-Side Comparison

                        FIFO          LIFO
Revenue (60 units × $20) $1,200       $1,200
Cost of Goods Sold          $660         $810
Gross Profit                $540         $390
Ending Inventory            $570         $420

Same transactions, same prices — dramatically different financial results.

Tax Implications

In a rising-price environment (inflation), LIFO produces higher COGS and lower taxable income — which means lower taxes. This is the primary reason many U.S. companies elect LIFO: it's a legal tax deferral strategy.

FIFO produces lower COGS and higher taxable income — meaning more taxes paid today. However, the balance sheet under FIFO better reflects the current replacement cost of inventory.

When Prices Are Falling

In a deflationary environment (or for technology products where prices drop over time), the effects reverse. FIFO would produce higher COGS (older, higher-cost inventory sold first) and LIFO would produce lower COGS.

Weighted-Average Cost

A third method — weighted-average cost — divides total cost by total units to get an average, then applies that average to all units sold. It smooths out price fluctuations and falls between FIFO and LIFO in most scenarios.

In our example: $1,230 ÷ 100 units = $12.30/unit. COGS for 60 units = $738. Ending inventory = $492.

FIFO vs LIFO: Which Should You Choose?

Choose FIFO if:

• You report under IFRS (LIFO is not permitted)
• You want your balance sheet to reflect current inventory values
• Your products are perishable or experience rapid obsolescence
• Tax minimization is less important than accurate reporting

Choose LIFO if:

• You report under U.S. GAAP and operate in an inflationary environment
• Deferring income taxes is a priority
• Your inventory physically turns over with newer items first (e.g., lumber piles)

Important: Once you elect a method, switching requires formal disclosure and restatement of prior periods — so choose carefully.

The LIFO Reserve

Companies using LIFO must disclose the LIFO reserve in their footnotes — the difference between LIFO inventory and what it would be under FIFO. Analysts use this to compare companies on an apples-to-apples basis.

Key Takeaway

FIFO and LIFO are not about physical inventory flow — they are accounting assumptions that determine how costs move through the income statement and balance sheet. In periods of rising prices, FIFO produces higher profits and higher taxes; LIFO produces lower profits and lower taxes. Knowing the trade-offs is essential for accounting exams, financial analysis, and business decision-making.