Inventory methods: FIFO, LIFO and weighted average compared
A company buys goods at different prices over a period, then sells some of them. Which purchase price belongs to the goods sold, and which to the goods still in stock? An inventory cost-flow method answers that, and the answer changes reported profit, tax and the balance sheet without changing a single real transaction.
The three methods
- FIFO (first in, first out): the oldest costs are matched with sales first. Cost of goods sold uses the earliest purchases; inventory is left holding the most recent.
- LIFO (last in, first out): the newest costs are matched with sales first. Cost of goods sold uses the latest purchases; inventory is left holding the oldest.
- Weighted average cost: every unit is given the same average cost: total cost of goods available divided by total units available.
Which methods are permitted depends on the accounting standard used. International standards do not allow LIFO, while US GAAP does. Check which framework a question assumes.
A worked example
A company starts with no stock and buys three batches of 100 units in a period of rising prices: 100 at 10, 100 at 12 and 100 at 14. It sells 150 units. Cost of goods available is 1,000 + 1,200 + 1,400 = 3,600.
FIFO. Cost of goods sold is the first 100 units at 10 plus 50 at 12: 1,000 + 600 = 1,600. Ending inventory is 3,600 − 1,600 = 2,000, made up of 50 at 12 and 100 at 14.
LIFO. Cost of goods sold is the latest 100 units at 14 plus 50 at 12: 1,400 + 600 = 2,000. Ending inventory is 3,600 − 2,000 = 1,600, made up of 100 at 10 and 50 at 12.
Weighted average. The average cost is 3,600 ÷ 300 = 12 per unit. Cost of goods sold is 150 × 12 = 1,800, and ending inventory is 150 × 12 = 1,800.
The three methods give three different answers for the same transactions, and the weighted average sits between the other two.
What happens when prices rise
With rising purchase prices, as in the example:
| FIFO | Weighted average | LIFO | |
|---|---|---|---|
| Cost of goods sold | lowest (1,600) | middle (1,800) | highest (2,000) |
| Gross profit | highest | middle | lowest |
| Ending inventory | highest (2,000) | middle (1,800) | lowest (1,600) |
- FIFO reports the highest profit and the highest inventory. Inventory is carried at recent costs, close to current replacement cost, but profit includes the gain from having bought cheaply.
- LIFO reports the lowest profit and so the lowest taxable income, where tax follows reported profit. Its cost of goods sold is closer to current costs, which matches today's sales with today's costs, but its inventory is stated at old, out-of-date costs.
When prices fall, everything reverses: LIFO shows the highest profit and FIFO the lowest.
LIFO reserve and comparing companies
Where LIFO is used, companies disclose the LIFO reserve: the difference between inventory under FIFO and under LIFO. It lets an analyst restate a LIFO company as if it used FIFO, which makes it comparable with one that does. The adjustment is to add the reserve to inventory, and to adjust cost of goods sold by the change in the reserve.
A related risk is LIFO liquidation. If a LIFO company sells more than it buys, it dips into old, low-cost layers and cost of goods sold falls, lifting profit for a reason unrelated to trading.
Effect on ratios
Because inventory and profit differ, so do the ratios built from them. In a period of rising prices, FIFO produces a higher current ratio and a lower inventory turnover than LIFO, because inventory is higher and cost of goods sold is lower. Comparing a FIFO company with a LIFO one on these ratios, without adjustment, is a mistake.
Mistakes to avoid
- Mixing up the direction. Rising prices: FIFO gives the highest profit, LIFO the lowest.
- Forgetting the periodic or perpetual distinction if a question specifies how the costs are tracked.
- Treating LIFO as available everywhere. It is not allowed under international standards.
- Ignoring the LIFO reserve when comparing companies.
Where this is tested
Inventory accounting is a standard part of financial statement analysis, and the choice of method affects ratios and the quality of earnings. The learning outcomes below set out the calculations and the adjustments.