Inventory Accounting Methods: FIFO, LIFO, and Their Impact

Key Takeaways

• Inventory method changes cost of goods sold, gross profit, taxes, and balance sheet values without altering cash flows directly.
• During inflation, FIFO usually reports higher profits and higher taxes, while LIFO reports lower profits and tax deferral.
• Weighted average smooths cost fluctuations and sits between FIFO and LIFO in most metrics.
• When comparing companies, adjust margins and ratios for accounting policy differences, and read footnotes for method and LIFO reserve details.
• You can use LIFO reserve disclosures to convert LIFO results to FIFO equivalents for apples-to-apples analysis.

Introduction

Inventory accounting methods determine how a company assigns cost to goods sold and to ending inventory. That choice affects reported profitability, taxes, and key ratios, yet it does not change physical inventory flows.

Why does this matter to you as an investor? Because two otherwise similar companies can show materially different profits and balance sheets just because they use different inventory methods. Which method gives a clearer picture of operating performance, and how should you adjust when comparing firms?

In this article you will learn how FIFO, LIFO, and weighted average work, why inflation matters, how to reconcile differences across firms, and practical steps you can use when analyzing companies. Ready to dig in?

How Inventory Methods Work

Inventory accounting answers a simple question: when you sell a unit, which purchase cost do you match against the sale? The common methods are FIFO, LIFO, and weighted average. Each assigns costs differently, changing cost of goods sold and ending inventory values.

FIFO: First-In, First-Out

FIFO assumes the earliest purchased items are sold first. In rising prices, older lower costs flow to COGS and the more recent higher costs remain in ending inventory. This tends to increase gross profit and asset values during inflation.

LIFO: Last-In, First-Out

LIFO assumes the most recently purchased items are sold first. When costs are rising, higher recent costs are matched to revenue, pushing COGS higher and reducing reported profit. LIFO can create a tax advantage in inflationary periods because taxable income is lower.

Weighted Average Cost

Weighted average smooths cost per unit across all purchases in the period. COGS and ending inventory are based on the average cost, reducing swings caused by volatile purchase prices. This is common in industries where goods are indistinguishable or purchases are frequent.

Real-World Example: FIFO vs LIFO During Inflation

Concrete numbers make the differences easy to see. Imagine a company sells 1,000 identical units during the year. They bought 1,000 units in two batches: 500 units at $10 and 500 units at $15. Sales price is $25 per unit.

1. FIFO COGS: first 500 at $10 and next 500 at $15, so COGS = 500*10 + 500*15 = $12,500. Gross profit = Revenue 1,000*25 minus COGS $12,500 = $12,500.
2. LIFO COGS: assume the last purchased units are sold first, so COGS = 500*15 + 500*10 = $12,500. In this two-batch, single-period example FIFO and LIFO produce the same totals because all units sold. The difference appears when some inventory remains unsold or when purchases and sales timing differ.

Now change the scenario so the company sold only 700 units. Under FIFO, COGS = first 500 at $10 plus 200 at $15 = 500*10 + 200*15 = $8,000. Ending inventory = 300 units, valued as 300*15 = $4,500. Under LIFO, COGS = 700 at most recent costs, 500 at $15 and 200 at $10 = 500*15 + 200*10 = $9,500. Ending inventory under LIFO = 300 units at older cost, 300*10 = $3,000. Gross profit FIFO = Revenue 700*25 - COGS 8,000 = 9,500. Gross profit LIFO = 17,500 - 9,500 = 8,000. The difference is $1,500, which impacts taxes and margins.

That $1,500 also shows up on the balance sheet as a $1,500 higher inventory under FIFO. Over many periods these differences compound, especially in prolonged inflation.

How Inventory Method Affects Financial Ratios and Taxes

An accounting policy is not neutral for ratio analysis. Investors should know which metrics are sensitive and how to adjust or interpret them.

Profitability and Margins

During inflation, FIFO usually produces higher gross and operating margins because lower historical costs stay in COGS. That makes margins look better, but may overstate current operating economics. LIFO tends to compress margins, reflecting more current replacement costs in COGS.

Liquidity and Balance Sheet Effects

FIFO raises reported current assets through higher inventory values, which can improve current and quick ratios. LIFO lowers inventory and might show weaker liquidity metrics, even if cash positions are the same.

Cash Taxes

Because LIFO reduces reported taxable income in rising-price environments, companies using LIFO may pay lower taxes now, deferring tax until LIFO layers are liquidated. That tax deferral is an important cash-flow consideration, and you should look for LIFO reserve trends in the footnotes.

Comparing Companies That Use Different Methods

When you're comparing two companies, different inventory policies can distort relative performance. You need to adjust or at least understand the direction of bias.

Use the LIFO Reserve

US GAAP requires companies using LIFO to disclose a LIFO reserve, which is the difference between inventory reported under FIFO and LIFO. You can add the LIFO reserve to LIFO inventory and adjust COGS to approximate FIFO-based results for comparability.

Adjust Key Metrics

Steps you can take when comparing:

• Convert LIFO to FIFO using the LIFO reserve to make gross margins comparable.
• Use adjusted EBITDA or operating income that strips accounting-driven COGS variances.
• Check trend lines, like gross margin over several years, to see if changes are due to accounting method or operational shifts.

If a company provides LIFO-to-FIFO reconciliation, use that disclosure. If not, you can still estimate adjustments by analyzing changes in the LIFO reserve year over year and the reported COGS.

Weighted Average and Other Practical Considerations

Weighted average is common for companies with homogeneous inventory, like commodity producers. It reduces noise from volatile purchase costs, but it can obscure short-term cost pressures.

International companies often use FIFO or weighted average because IFRS does not allow LIFO. This creates a cross-border comparability issue, especially when comparing US LIFO users to IFRS firms.

Inventory Write-Downs and Valuation

No matter the method, companies must write down inventory if net realizable value falls below cost. That creates a floor that prevents inventory from being carried above recoverable amounts. You should watch write-downs because frequent or large write-offs may signal inventory management problems.

Practical Example: Converting LIFO to FIFO Using LIFO Reserve

Suppose a company reports ending inventory under LIFO of $30 million and discloses a LIFO reserve of $10 million. The FIFO equivalent inventory is $40 million. If the company sold $100 million of goods and the LIFO reserve increased by $2 million during the year, you can adjust COGS to approximate FIFO.

1. Reported LIFO COGS = $100 million.
2. Increase in LIFO reserve = $2 million, meaning FIFO COGS would be $100 million minus $2 million = $98 million.
3. This adjustment raises gross profit and gross margin to the FIFO basis, allowing better comparison with FIFO peers.

Using LIFO reserve movements lets you convert historical results and calculate adjusted margins. Make sure you read the footnotes for the exact definition the company uses.

Common Mistakes to Avoid

• Assuming inventory method indicates operational quality. Accounting choice affects reported profits, but it does not imply better or worse operations. Focus on margins after adjusting for accounting differences.
• Ignoring the LIFO reserve. If you compare a LIFO user with FIFO peers without adjusting, you may overstate the FIFO company's profitability. Always check the footnotes.
• Confusing cash flow with accounting profit. LIFO can lower taxable income and produce tax deferral, but this is an accounting timing effect, not extra cash from sales.
• Overreacting to one-year swings. Inventory-driven margin movements often reflect price cycles or timing, so look at multi-year trends.
• Not considering international differences. IFRS prohibits LIFO. Comparing US LIFO companies to IFRS peers requires conversion or careful caveats to avoid apples-to-oranges conclusions.

FAQ

Q: Which method is most common globally?

A: FIFO and weighted average are the most common globally because IFRS disallows LIFO. In the US, some companies still use LIFO, especially in industries exposed to inflationary raw material costs.

Q: Does changing inventory method affect cash flow?

A: Changing methods does not directly change operating cash flow from sales and purchases. It affects taxable income and therefore income taxes paid, which can change cash flow timing. You should check tax footnotes for cash effects.

Q: How do I find a company's inventory method?

A: Review the notes to the financial statements. Companies disclose the inventory valuation method and, if they use LIFO, the LIFO reserve. Management discussion may also explain inventory-related trends.

Q: Can I rely on gross margin comparisons across industries?

A: Gross margin comparisons are only useful within similar business models and accounting methods. Always adjust for inventory method differences and consider industry-specific cost structures before drawing conclusions.

Bottom Line

Inventory accounting choices matter for investors because they change reported profit, taxes, and balance sheet metrics. FIFO, LIFO, and weighted average each have predictable effects in periods of rising or falling prices. You should not treat reported numbers at face value when inventory accounting differs across companies.

Practical next steps for you: read the inventory accounting footnotes, check for a LIFO reserve if applicable, adjust margins when comparing peers, and focus on multi-year trends rather than single-period swings. At the end of the day, understanding inventory accounting helps you make cleaner comparisons and better-informed investment assessments.