FIFO, LIFO & Weighted Average
Cost flow methods—which inventory costs hit your income statement?
Why This Matters
You buy 100 widgets in Jan for $10 each. In Mar, you buy 100 more—but now they cost $15 each. You sell 50 widgets in April.
Question: What's your Cost of Goods Sold?
- • Is it $500 (50 × $10 from Jan)?
- • Is it $750 (50 × $15 from Mar)?
- • Is it $625 (50 × $12.50 average)?
All three answers are correct—depending on which cost flow method you choose.
This isn't a trick question. It's one of the most consequential accounting decisions a company makes. The method you pick affects:
Visual: The Warehouse Shelf
Imagine your inventory as boxes on a shelf. Different methods pull boxes off differently:
INVENTORY ARRIVES (Older → Newer)
FIFO: First-In, First-Out
Oldest boxes leave first (like grocery store milk).
LIFO: Last-In, First-Out
Newest boxes leave first (like a coal pile or gravel heap).
Weighted Average
All boxes blend into one average cost (like a gas station tank).
When Prices Are Rising
FIFO Effects
- • COGS uses older, LOWER costs
- • Result: Lower COGS
- • Result: Higher gross profit
- • Result: Higher taxes
- • Inventory Value: Higher
Weighted Avg Effects
- • Results fall BETWEEN FIFO and LIFO
- • Moderate COGS
- • Moderate profit
- • Moderate taxes
- • Inventory Value: Moderate
LIFO Effects
- • COGS uses newer, HIGHER costs
- • Result: Higher COGS
- • Result: Lower gross profit
- • Result: Lower taxes ✨
- • Inventory Value: Lower
Important: LIFO is NOT allowed under IFRS (international standards). Only US GAAP permits LIFO. If you're outside the US or reporting internationally, LIFO isn't an option.
Complete Example: TechGadget Store
Scenario: TechGadget Store sells wireless earbuds. January activity:
| Date | Transaction | Units | Cost/Unit | Total Cost |
|---|---|---|---|---|
| Jan 1 | Beg. inventory | 100 | $20 | $2,000 |
| Jan 10 | Purchase | 150 | $22 | $3,300 |
| Jan 20 | Purchase | 200 | $25 | $5,000 |
| Total Available | 450 | $10,300 | ||
| Jan 31 | Sold | 300 | ??? (COGS) | |
| Ending inventory | 150 | ??? | ||
Results Comparison (Assuming 300 units sold, 150 remain)
| Method | COGS | Ending Inventory | Gross Profit (if sales=$15k) |
|---|---|---|---|
| FIFO | $6,550 (Lowest) | $3,750 | $8,450 (Highest) |
| Weighted Avg | $6,867 (Middle) | $3,433 | $8,133 (Middle) |
| LIFO | $7,200 (Highest) | $3,100 | $7,800 (Lowest) |
Why Companies Choose Each
Choose FIFO When:
- • You want to report higher profits
- • Industry expects it (perishables, fashion)
- • You need IFRS compliance
- • Physical flow matches FIFO
Choose LIFO When:
- • You want to minimize taxes
- • Cash flow matters more than reported profit
- • Reporting only under US GAAP
LIFO Conformity Rule: If you use LIFO for taxes, you MUST use it for financial reporting.
The LIFO Reserve
Companies using LIFO must disclose what inventory WOULD be under FIFO. The difference is the LIFO Reserve.
LIFO Reserve = FIFO Inv. - LIFO Inv.
From example:
$3,750 - $3,100 = $650
This represents "hidden" value not on the balance sheet and taxes that have been deferred. Analysts add this back to compare companies on an apples-to-apples basis.
Key Takeaway
FIFO, LIFO, and Weighted Average are methods for assigning costs to inventory sold. The method you choose doesn't change how many units you sold—it changes how much profit you report and how much tax you pay.
FIFO assumes oldest costs go to COGS first (higher profits, higher taxes when prices rise). LIFO assumes newest costs go to COGS first (lower profits, lower taxes). Same reality, different numbers.
Test Your Understanding
See if you've got the basics down. Click each option and check your answer.
Question 1: When prices are rising, which method results in the HIGHEST net income?
Question 2: Which inventory method is NOT permitted under IFRS (International Financial Reporting Standards)?
Question 3: Inventory: Beg=50 units @ $10, Purch 1=50 units @ $12, Purch 2=50 units @ $14. Sold 75 units. Under FIFO, what is COGS?
Question 4: The 'LIFO Reserve' represents:
Question 5: A company wants to minimize taxes during a period of rising prices. Which method should they choose (assuming US GAAP)?
Ready to Practice?
You now understand how cost flow methods work. The Practice Lab lets you calculate COGS under all three methods, see the tax impact in real numbers, and compare financial statements side-by-side.
Try the Practice LabWhat's Next?
You know how to value inventory when it's purchased. But what happens when inventory loses value? That's where Lower of Cost or Market (LCM) comes in.