FIFO vs LIFO: Key differences, formulas and examples

Tracking costs accurately is essential for effective inventory management. Two of the most common inventory valuation methods are FIFO (First In, First Out) and LIFO (Last In, First Out). 

These methods impact everything from your cost of goods sold (COGS) to your taxable income and profitability. 

But what are the key differences between FIFO and LIFO? 

How do you calculate FIFO and LIFO, and which method is right for your business? 

By the end, you will have a clear understanding of inventory valuation and a better insight into how inventory management software simplifies the management of FIFO and LIFO.

Here’s what we’ll cover:

What is FIFO?

FIFO (First In, First Out) is an inventory valuation method where your business sells or uses the oldest stock first. 

This approach mirrors the natural flow of inventory, making sure older products are used before they expire or become obsolete. 

Why FIFO matters for your business

It increases net profit in inflationary periods because older, cheaper inventory is used first.

It reduces waste when your business is dealing with perishable goods.

It reflects current inventory value more accurately when prices are rising. 

Advantages and disadvantages of FIFO

Choosing FIFO as your inventory valuation method can significantly impact your business’s profitability, tax liability, and financial reporting. 

Understanding the benefits and potential drawbacks will help you decide whether FIFO fits your inventory management strategy. 

Advantages

Good for record-keeping

FIFO constantly uses up the oldest inventory layers, reducing the need for extensive records.

This makes it easier to monitor your inventory value and predict gross profit. 

Higher profits during inflation

Since FIFO sells older, lower-cost inventory first, your profits appear higher when prices rise. 

Reflects actual inventory flow

This method follows the natural movement of stock, making it ideal if your business sells perishable or time-sensitive products. 

Improves financial transparency

FIFO clarifies inventory costs and aligns well with financial reporting standards. 

Disadvantages

Higher taxes during inflation

Increased profits result in a higher taxable income, which could lead to more significant tax liabilities for your business. 

Less accurate cost tracking in volatile markets

If inventory prices fluctuate frequently, using older costs for COGS may not reflect the true cost of replacement stock, potentially impacting pricing decisions.

What is LIFO?

LIFO (Last In, First Out) is the opposite of FIFO—it assumes that the newest inventory is sold first, while older stock remains on the books. 

This method can significantly impact your business’s financial statements, especially during inflation. 

The LIFO formula

The LIFO formula represents: 

LIFO Cost of Goods Sold (COGS) = cost of newest inventory × units sold

Advantages and disadvantages of LIFO

LIFO can be a strategic choice for businesses looking to reduce taxable income, but it also has limitations depending on accounting regulations and financial reporting goals. 

Here’s a breakdown of its pros and cons: 

Advantages

Higher COGS and lower taxable income during inflation

LIFO help your business reduce tax liability by using newer, more expensive inventory first. This method is great for keeping tax costs low. 

It’s useful for retail companies that need to stay on top of trends and quickly sell fashionable items. 

It’s also helpful for supermarkets dealing with fluctuating food prices.

Can improve cash flow

By lowering taxable income, your business may have more cash on hand. 

Disadvantages

Not permitted under IFRS

If you’re an international business, you may not be allowed to use LIFO for tax purposes. 

Lower inventory value on financial statements

Since older, lower-cost inventory remains on the books, it can make your financial statements look weaker.

LIFO and FIFO examples

Understanding how FIFO and LIFO impact cost of goods sold (COGS) is easier with real-world examples.

Below, see how each method is applied to the same inventory purchases and sales, leading to different financial outcomes. 

Example of calculating FIFO

Imagine you are the inventory manager of a clothing store warehouse. 

Your business purchases inventory in the following order. 

• January: 100 units at $10 each
• February: 100 units at $12 each

Later, in March, a total of 120 units are sold. 

Using the FIFO inventory method formula, the oldest stock is sold first:

• The first 100 units from the January purchase are sold at $10 each.
• The remaining 20 units come from the February purchase at $12 each.

COGS = (100×10) + (20×12)

COGS= 1000 + 140 = 1,240

Therefore, the cost of goods sold (COGS) under FIFO is $1,240.

Example of calculating LIFO

Using the same purchase data, imagine your business buys inventory on the following dates:

• January: 100 units at $10
• February: 100 units at $12

Later, in March, your business sells 120 units. 

Under LIFO inventory method formula, the most recent stock is sold first: 

• The first 100 units from the February purchase are sold at $12 each.
• The remaining 20 units come from the January purchase at $10 each.

COGS = (100×12) + (20×10)

COGS = 1,200 + 200 = 1,400

Your cost of goods sold (COGS) under LIFO is $1,400, which is higher than FIFO’s $1,240. 

This example highlights how LIFO results in higher costs and lower reported profits, particularly during periods rising prices, making it a common choice for businesses looking to reduce taxable income.

FIFO vs. LIFO: Key differences

FIFO and LIFO differ in how they manage inventory costs, affecting financial statements, tax liabilities, and overall business profitability. 

Here’s how they compare:

Cost flow assumption

FIFO follows a First In, First Out approach, meaning the oldest inventory is sold first. 

LIFO, on the other hand, operates under a Last In, First Out assumption, where the newest inventory is sold first.

Inventory valuation

FIFO calculates cost of goods sold (COGS) based on older, lower-cost inventory, while LIFO uses the most recent, higher-cost inventory for COGS calculations. 

Impact of inflation

FIFO typically results in lower COGS and higher profits, leading to higher taxes when prices are rising. 

In contrast, LUFO leads to higher COGS and lower profits, which can help businesses reduce taxable income during inflation. 

Complexity of fluctuation reporting

Using FIFO, the cost of goods usually stays stable, making it easy to track inventory and costs. 

Prices can change with inflation or deflation, but the inventory layers generally show recent prices. 

With LIFO, inventory layers can stick around for a long time, making average costs vary and reporting tricky. 

These layers make it hard to report price changes, as altering one can affect the cost of items sold.

Balance sheet impact

FIFO values ending inventory at the most recent (and often higher) purchase costs, making financial statements appear stronger. 

LIFO, however, values inventory at older, lower costs, which can make your balance sheet look weaker. 

Regulatory compliance

FIFO is permitted under both IRS and GAAP, making it a globally accepted inventory valuation method. 

LIFO, however, is not allowed under IFRS but remains permitted under US GAAP, making it a viable option if you’re business is based in the U.S.

Choosing between FIFO and LIFO depends on your business goals, tax strategy, and financial reporting needs.

If reducing taxable income is a priority for your financial strategy, LIFO may be beneficial—if allowed in your region. 

For a more transparent and widely accepted method, FIFO is often the preferred choice.

Other factors to consider when choosing FIFO vs LIFO

Regulatory compliance

Some countries do not allow LIFO for tax purposes (e.g., IFRS does not permit LIFO).

Tax implications

LIFO can be beneficial in times of inflation to lower taxable income.

Inventory management

FIFO aligns with the natural flow of goods, making it ideal for perishable items. 

LIFO vs. FIFO vs. Weighted average cost

While FIFO and LIFO are the most used methods, weighted average cost (WAC) offers a third options that smooths out price fluctuations. 

Here’s how each method stacks up:

FIFO

• Lower COGS and higher profits during inflation.
• Provides a clearer picture of inventory costs.

LIFO

• Higher COGS and lower profits during inflation.
• Reduces taxable income by increasing expenses.

Weighted average cost (WAC)

• Average inventory costs by dividing the total cost of goods available for sale by the total units available, creating a consistent per-unit cost. 
• Smooths out price fluctuations, making it a balanced approach between FIFO and LIFO. 

Which method is best for your business?

Choose Weighted Average Cost for a balanced approach that minimizes price fluctuations.

Choose FIFO if you want higher profits and accurate inventory tracking.

Choose LIFO to lower taxable income during inflation (if allowed).

Strengthen your finances inventory management software

Whether you run a small or growing business, the right inventory management software helps streamline operations by automating FIFO, LIFO, or Weighted Average Cost calculations. 

Built-in tools for tracking, valuing, and managing stock makes sure your team stays accurate and efficient at every stage of the inventory process.

With the right solution, you can:

• Track inventory costs with ease: monitor stock movements and pricing in real time to maintain precise records. 
• Generate real-time financial reports: gain valuable insights into inventory costs, profitability, and trends to support better decision-making.
• Ensure tax compliance: automate calculations and reporting to meet regulatory requirements and avoid costly errors. 

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