FIFO, LIFO or Average Cost? Choosing an Inventory Costing Method

Three deliveries of the same product this year: $10 a unit in spring, $12 in summer, $15 in autumn. A customer just bought one. Write down what it cost you.

Whatever you wrote is defensible, and so are the two answers you didn't write. That is the strange, deliberate flexibility at the centre of inventory costing methods — the same unit can honestly cost $10, $12.33 or $15 depending on which convention your books follow. Every one of those figures is permitted. Every one produces a different gross margin, a different balance sheet and a different tax return.

For anyone who holds stock, this is among the most consequential settings in the entire ledger, and it usually gets chosen by accident. What follows puts all three main methods through one identical set of numbers, explains what the tax authorities and the international standards will and won't allow, and gives you a way to decide.

Why One Product Ends Up With Several Costs

Stock arrives in consignments, and consignment prices wander. A supplier lifts their list price, a freight surcharge appears, a bulk order earns a discount, an urgent reorder costs a premium. Long before a customer reaches the shelf, you're holding units acquired at three or four different prices that look completely identical to each other.

When one leaves, the ledger has to answer something the stockroom never asks: which one was it? Nobody is going to barcode individual washers, so the standards permit a consistent assumption in place of the truth. That assumption is your costing method — and note that it governs the movement of cost, not the movement of goods. Rotating your warehouse strictly oldest-first is perfectly compatible with running LIFO on paper.

The stakes are high because cost of goods sold is normally the biggest line on a product business's income statement. Shift COGS and you shift gross profit, net profit and tax. The example below shows by how much.

One Set of Numbers, Three Costing Methods

Picture a shop that began the year with nothing on the shelf and restocked three times:

Across the year they sell 150 units at $25, so revenue is $3,750 and 150 units remain unsold. Identical stock, identical sales, three conventions.

FIFO — earliest batch out first

Under FIFO the 150 units sold are drawn from March first (100 at $10), then July (50 at $12). That's $1,600 of cost of goods sold. Left behind is your freshest stock — 50 units at $12 plus 100 at $15 — so closing inventory is $2,100.

LIFO — latest batch out first

Under LIFO the same 150 units are drawn from October first (100 at $15), then July (50 at $12), producing $2,100 of cost of goods sold. What's left is your oldest stock — 100 at $10 plus 50 at $12 — so closing inventory is $1,600.

Weighted average — one blended cost

Weighted average dissolves the batches entirely: $3,700 spread over 300 units gives $12.33 each. Sell 150 and cost of goods sold is $1,850, with the surviving 150 units also carried at $1,850. Nothing to track but a single running figure.

That's $500 of gross profit — around 30% of the total — appearing and disappearing purely on convention. Look also at the arithmetic underneath: in all three columns, cost of goods sold plus closing inventory comes to the same $3,700. No cost is invented or lost. All that changes is how much you expense this year and how much you carry forward on the balance sheet.

Your costing method doesn't alter what you paid. It only decides which year you're allowed to say you paid it.

There's a second, slower consequence in that table. FIFO leaves your most recent prices sitting in stock, so the inventory figure stays near replacement cost. LIFO leaves the oldest ones there — run it long enough and your balance sheet can be valuing today's stock at prices from another decade.

Which Inventory Costing Method Should a Small Business Choose?

In most cases the answer is FIFO, and not because it makes profit look better. It corresponds to how goods genuinely rotate anywhere stock has a shelf life, a season or a model year. It keeps the inventory asset honest against current prices. It satisfies US GAAP and IFRS alike. And it demands nothing of you administratively — no election, no form, no explanation to anyone.

Weighted average comes into its own where the units are truly interchangeable and prices refuse to sit still: fuel, grain, resins, fixings, raw chemicals. Keeping a separate cost layer per delivery of an identical commodity is work that buys you no additional accuracy. Averaging also damps out volatility, so one unusually expensive load doesn't wreck a single month's margin.

LIFO belongs in a different category — it's a tax position rather than a bookkeeping preference. While prices climb, it pushes your dearest costs through cost of goods sold and defers tax. That's genuine cash, but it arrives attached to conditions (below), and it simultaneously makes your margins look thinner to any bank or acquirer reading your accounts. It deserves a discussion with your accountant, not a quick change in a settings screen.

Specific identification is the fourth option and the only one that answers "which unit sold?" honestly rather than by convention. Selling a dozen used vans a year? Use it — the record-keeping is trivial and the result is exact. Selling a dozen thousand identical rivets? It's impossible, which is the entire reason the other three conventions exist.

The Constraints Around Your Choice

Few areas of small business accounting are as tightly fenced as this one. Four rules shape what you can do:

• You have to stay consistent. Both the accounting standards and the tax code expect the same method year after year. Hopping between methods to produce a convenient result is exactly the behaviour the consistency principle was written to stop.
• LIFO has to be elected. In the US you take it up by filing Form 970 with your return, after which the LIFO conformity rule applies: use LIFO for tax and you're obliged to use it in the accounts you hand to lenders and investors too. There's no showing the bank a FIFO profit and the IRS a LIFO one.
• IFRS rules LIFO out completely. IAS 2 allows FIFO, weighted average and specific identification, and nothing else. If you report under IFRS — or expect to, because of an overseas parent, investor or lender — the question is already settled.
• Stock can be marked down but never back up. Under GAAP, inventory held at FIFO or average cost is measured at the lower of cost and net realisable value. Goods that go obsolete or fall below what you paid get written down. A later recovery in market price doesn't let you write them back up.

Reversing your decision afterwards typically means IRS consent via Form 3115 plus restated comparatives in your accounts. Which is the practical argument for deciding carefully at the outset: this is far cheaper to get right once than to unpick later. Our guide to GAAP for small business explains at what point these standards start to bite for a company your size.

The Bit That Trips People Up: Keeping the Layers

FIFO and LIFO are a sentence to explain and a slog to maintain, because both depend on cost layers — an ongoing record of each delivery, what it cost per unit, and how many of its units survive. Every sale has to walk that stack, retire the right layers in the right sequence and post the resulting cost.

Spreadsheets fold under this fast. Forty products with a dozen deliveries each is 480 layers to hand-maintain, and a single slip spreads quietly forward: cost of goods sold is wrong, gross margin is wrong, and the stock figure is wrong on your profit and loss statement and balance sheet simultaneously. That's the actual reason so many businesses drift into costing stock at "roughly what we last paid" — nobody chose it, the record-keeping simply gave way.

How Kantivo Does the Costing

Kantivo offers FIFO, LIFO and average cost. Choose one in Inventory Settings and it governs every sale thereafter. Real cost layers are maintained underneath, so each sale retires the right delivery in the right order and the cost of goods sold figure is computed rather than guessed.

The accounts behind it are configured in the same screen: your inventory asset account, your COGS account, and separate accounts for inventory adjustments and shrinkage — so a stock-count variance or a write-down lands somewhere you chose rather than vanishing into a general expense line. Given the tax consequences, changing your costing method raises an explicit warning instead of saving quietly, and any company set to report under IFRS has LIFO switched off automatically, because IAS 2 forbids it. That's the same per-company GAAP/IFRS setting that drives your statement titles and presentation order.

Everything posts as proper double-entry bookkeeping into your general ledger, on hardware you own, with the data held locally — not in a workbook you nurse along by hand, and not on somebody else's servers.

The Takeaway

Your inventory costing method quietly decides which purchase price gets expensed against each sale — and in the example above, that decision alone shifted gross profit by $500 on $3,750 of revenue while not a single unit moved differently. FIFO is the sensible starting point for most small businesses: it tracks how stock really rotates, keeps the balance sheet current, and passes under both GAAP and IFRS. Turn to weighted average when your units are interchangeable and prices jump about. Treat LIFO as what it is — a deliberate American tax position with an election, a conformity rule and an accountant attached. Choose once, apply it faithfully, and let the software carry the layers so the figure is right every single time instead of most of the time.

Frequently Asked Questions

What does an inventory costing method actually do?

It settles which purchase price gets charged against a sale. Because you buy the same product repeatedly at drifting prices, your books need a rule for deciding which batch a sold unit came from. US GAAP recognises four such rules: FIFO, LIFO, weighted average and specific identification. The rule you adopt sets your cost of goods sold, and therefore your gross margin and your taxable profit.

Which costing method should a small business choose?

Start from FIFO unless you have a specific reason not to. It reflects the way stock genuinely moves in most businesses, values what's left on the shelf at something close to today's replacement cost, and is acceptable to both US GAAP and IFRS without any filing. Reach for weighted average when your units are indistinguishable commodities bought at volatile prices. Consider LIFO only alongside your accountant, as a deliberate tax position.

Why do FIFO and LIFO produce different profits?

Because they expense different batches. With prices climbing, FIFO releases your earliest and cheapest costs into cost of goods sold, so profit reads higher and the stock still on hand carries a higher value. LIFO releases your most recent and dearest costs, so profit reads lower and the remaining stock is valued at older, cheaper prices. Weighted average settles in the middle. Nothing physical differs between the three.

Can a company reporting under IFRS use LIFO?

It cannot. IAS 2 removed LIFO as an acceptable option, leaving FIFO, weighted average and specific identification. The method survives in the United States because US GAAP and the tax code still permit it, which makes LIFO effectively a domestic American choice and a poor one for any business with international reporting obligations.

How hard is it to switch costing methods after the fact?

Harder than choosing well the first time. Consistency between periods is a requirement, not a courtesy, and in the United States switching usually means asking the IRS for consent on Form 3115. Taking up LIFO in the first place requires an election on Form 970, and the conformity rule then obliges you to present LIFO figures to lenders and investors as well as to the tax authorities. Get your accountant involved before you touch it.

Does Kantivo calculate FIFO, LIFO and average cost for me?

It does. Choose FIFO, LIFO or average cost once in Inventory Settings and Kantivo applies it to every sale from then on, maintaining genuine cost layers so the correct purchase batch is consumed and the cost of goods sold entry posts to the accounts you nominate. It warns you before any change of method because of the tax implications, and it switches LIFO off automatically for companies reporting under IFRS.

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