Inventory Accounting: FIFO, LIFO, and What to Use

Why Inventory Accounting Matters

If you sell physical products — whether you are a retailer, distributor, manufacturer, or contractor who stocks materials — how you account for inventory directly affects your reported profit, your tax bill, and your understanding of business health.

The core question inventory accounting answers: When you sell a product, what was its cost? That sounds simple until you realize you bought the same product at different prices throughout the year. Which cost do you use?

The answer depends on which inventory method you choose.

The Three Main Methods

FIFO: First In, First Out

FIFO assumes the oldest inventory is sold first. The cost of goods sold reflects the price of the oldest items in stock, and the remaining inventory on your balance sheet reflects the newest (most recent) prices.

Example: You buy 100 widgets in January at $10 each, and 100 more in June at $12 each. You sell 100 widgets. Under FIFO, the cost of those 100 sold is $10 each ($1,000 total), because the January inventory goes out first.

Advantages:

• Matches the physical flow of most businesses (you sell oldest stock first)
• Balance sheet inventory value reflects current market prices
• Generally results in higher reported profit during inflationary periods
• Accepted under both GAAP and IFRS

Disadvantages:

• Higher reported profit means higher taxes when prices are rising
• COGS may not reflect current replacement costs

LIFO: Last In, First Out

LIFO assumes the newest inventory is sold first. COGS reflects the most recent (usually higher) prices, while remaining inventory reflects older (usually lower) prices.

Using the same example: You sell 100 widgets. Under LIFO, the cost is $12 each ($1,200 total), because the June inventory goes out first.

Advantages:

• Lower taxable income during inflation (newer, higher costs reduce profit)
• COGS better reflects current replacement costs
• Tax deferral benefit in periods of rising prices

Disadvantages:

• Balance sheet inventory value may be understated (old prices)
• Not allowed under IFRS (matters if you have international operations)
• Requires maintaining LIFO reserves
• IRS conformity rule: if you use LIFO for taxes, you must also use it for financial reporting

Weighted Average Cost

This method calculates the average cost of all inventory available during the period and uses that average for both COGS and ending inventory.

Using the same example: Total cost: $1,000 + $1,200 = $2,200 for 200 widgets. Average cost: $11 each. Selling 100 widgets = $1,100 COGS.

Advantages:

• Simple to calculate and maintain
• Smooths out price fluctuations
• Good for businesses with large volumes of similar items

Disadvantages:

• Does not reflect actual physical flow
• May not optimize tax position

Which Method Should You Use?

Use FIFO If:

• Prices are stable or declining
• You want your balance sheet to reflect current inventory values
• Your business physically sells oldest stock first (perishables, dated products)
• You want simplicity and GAAP compliance

Use LIFO If:

• Prices are consistently rising
• You want to minimize current tax liability
• You are a US-based business (LIFO is not allowed under IFRS)
• You can maintain the required LIFO reserve calculations

Use Weighted Average If:

• You deal in large quantities of similar, interchangeable items
• Price fluctuations are moderate
• You want the simplest calculation
• Precision between FIFO and LIFO is not critical to your decision-making

The Tax Implications

The method you choose directly impacts taxable income. In an inflationary environment:

| Method | COGS | Gross Profit | Tax Impact | |--------|------|-------------|------------| | FIFO | Lowest (old prices) | Highest | Higher taxes | | LIFO | Highest (new prices) | Lowest | Lower taxes | | Weighted Average | Middle | Middle | Middle |

Over the long term, total profit recognized is the same under all methods. The difference is timing — which years carry more or less tax burden.

The IRS requires consistency. Once you choose a method, you generally must stick with it. Changing methods requires filing Form 3115 (Application for Change in Accounting Method).

Inventory Management Beyond Accounting

The accounting method is only part of the picture. Good inventory management also requires:

Regular Physical Counts

At least annually, physically count every item in inventory and compare to your records. Shrinkage (theft, damage, miscounts) is real and needs to be identified.

Inventory Turnover Monitoring

Formula: COGS / Average Inventory

High turnover means inventory is moving quickly. Low turnover means cash is sitting on shelves.

Reorder Point Calculation

Know when to reorder based on lead times and sales velocity. Running out of stock loses sales. Overstocking ties up cash.

Obsolescence Review

Regularly review inventory for items that are not selling. Obsolete inventory should be written down to net realizable value, not left on the books at full cost pretending it is still worth something.

The Lower of Cost or Market Rule

Under GAAP, inventory must be reported at the lower of its cost or its market value (net realizable value). If you have inventory that cost $50 per unit but now sells for $30, you must write it down to $30 on your balance sheet.

This prevents your financial statements from overstating asset values. It is not optional.

Small Business Exception

Under the Tax Cuts and Jobs Act, businesses with average annual gross receipts of $29 million or less can treat inventory as non-incidental materials and supplies. This means you can deduct inventory costs when purchased rather than when sold. This is a significant simplification for qualifying small businesses. Talk to your accountant about whether this applies to you.

The Bottom Line

Inventory accounting is not just record keeping. It is a tax strategy and a management tool. Choose the method that matches your business reality and tax goals, maintain accurate records, and review inventory health regularly. The wrong method quietly costs you money through higher taxes or misleading financial statements. The right method, consistently applied, gives you control.