Inventory Costing: FIFO, LIFO and Weighted Average
When unit costs change over time, the order you assume goods are sold in — first-in-first-out, last-in-first-out, or a blended average — changes reported profit and inventory value even though nothing about the actual business changed.
Prerequisites: Reading an Income Statement, Reading a Balance Sheet
A company buys the same product at three different prices over the year as its supplier raises prices with inflation. When it sells a unit, which of those three costs does it charge against revenue? The physical units on the shelf may be identical and interchangeable, but accounting requires picking an assumption about which cost layer left the warehouse first — and that choice changes gross profit, taxes, and the inventory value on the balance sheet, even though not a single real dollar of cash flow is different.
FIFO assumes the oldest, usually cheapest, inventory is sold first, leaving the newest, most expensive costs on the balance sheet. LIFO assumes the newest, usually most expensive, inventory is sold first, leaving old, cheap costs on the balance sheet. Weighted average blends all costs into one number per unit. In rising-price environments, FIFO reports higher profit and higher inventory value; LIFO reports lower profit, lower inventory value, and lower taxes.
The mechanics
Say a company buys inventory in three batches during the year, prices rising each time: 100 units at $10, then 100 units at $12, then 100 units at $14. It sells 150 units.
- FIFO: the 150 units sold are costed as the first 100 ($10 each) plus the next 50 ($12 each): , i.e. $1,600 cost of goods sold. Remaining inventory: 50 units at $12 + 100 at $14 = $2,000.
- LIFO: the 150 units sold are costed as the last 100 ($14 each) plus the next 50 ($12 each): , i.e. $2,000 cost of goods sold. Remaining inventory: 100 units at $10 + 50 at $12 = $1,600.
- Weighted average: total cost $3,600 across 300 units = $12/unit. Cost of goods sold: , i.e. $1,800. Remaining inventory: $1,800.
Worked example: the earnings effect
Using the numbers above, suppose the company sells the 150 units for $25 each, total revenue $3,750.
- FIFO gross profit: , i.e. $2,150.
- LIFO gross profit: , i.e. $1,750.
The identical sale produces $400 more reported profit under FIFO than LIFO, purely from the costing method — and in the US, a company using LIFO for tax purposes must also use it for financial reporting (the "LIFO conformity rule"), so this isn't just a paper choice, it changes the actual tax bill too.
What this means in practice
In an inflationary environment, comparing gross margins across two companies in the same industry is meaningless if one uses FIFO and the other LIFO — the LIFO company will look structurally less profitable even with identical operations. US GAAP allows LIFO; IFRS bans it entirely, which is one reason cross-border comparisons of inventory-heavy companies require adjustment.
LIFO's tax advantage evaporates, and can reverse painfully, if a company sells down old inventory layers faster than it replaces them — a "LIFO liquidation" releases decades-old low costs into current cost of goods sold, producing an artificial profit spike that has nothing to do with the current period's operations.
Related concepts
Practice in interviews
Further reading
- FASB ASC 330, Inventory
- Penman, Financial Statement Analysis and Security Valuation (ch. on inventory)