Understanding Inventory Costing Methods
When a business buys inventory at different prices over time and then sells those items, it needs a method to determine which cost to assign to the items sold. This is where inventory costing methods come in. The two most common methods are FIFO and LIFO. FIFO, which stands for First In First Out, assumes that the first items purchased are the first items sold. LIFO, which stands for Last In First Out, assumes that the most recently purchased items are sold first. A third method, weighted average cost, calculates an average cost across all units available for sale. The method chosen does not need to match the physical flow of goods. A grocery store may physically sell older produce first, but a hardware store might pull from the most accessible shelf regardless of when items were stocked. The costing method is an accounting assumption, not a description of physical movement.
How FIFO Works
Under FIFO, the cost assigned to items sold comes from the oldest inventory purchases. Suppose you buy one hundred widgets at five dollars each in January, then one hundred more at six dollars each in March. When you sell one hundred fifty widgets in April, FIFO assigns the cost as follows: the first one hundred units are costed at five dollars (January purchase) and the remaining fifty units at six dollars (March purchase), for a total cost of goods sold of eight hundred dollars. The remaining inventory of fifty units is valued at six dollars each, totaling three hundred dollars. FIFO generally results in a higher ending inventory value and lower cost of goods sold during periods of rising prices, because the cheaper, older costs are assigned to items sold while the more expensive, recent costs remain in inventory.
How LIFO Works
Under LIFO, the cost assigned to items sold comes from the most recent inventory purchases. Using the same example, when you sell one hundred fifty widgets in April, LIFO assigns the cost as follows: the first one hundred units are costed at six dollars (March purchase, the most recent) and the remaining fifty units at five dollars (January purchase), for a total cost of goods sold of eight hundred fifty dollars. The remaining inventory of fifty units is valued at five dollars each, totaling two hundred fifty dollars. LIFO generally results in higher cost of goods sold and lower ending inventory during periods of rising prices. This means lower reported profit and, consequently, lower income taxes. This tax advantage is the primary reason some businesses choose LIFO, though it is not permitted under international financial reporting standards (IFRS).
Choosing Between FIFO and LIFO
The choice between FIFO and LIFO depends on several factors. FIFO better represents the actual flow of goods for most businesses and results in inventory values on the balance sheet that closely match current market prices. LIFO can reduce tax liability during inflationary periods but results in older, potentially understated inventory values on the balance sheet. In the United States, LIFO is permitted for tax and financial reporting, but if you use LIFO for taxes, you must also use it for financial reporting. Internationally, LIFO is not allowed under IFRS. Many businesses choose FIFO for its simplicity and because it produces financial statements that more accurately reflect current values. HelloBooks supports multiple inventory costing methods, allowing you to choose the method that best fits your business and tax strategy.