FIFO vs. LIFO in Inventory Costing

CostFlow Analytics

FIFO LIFO Comparison

FIFO vs. LIFO: Unpacking Inventory Costing

First-In, First-Out (FIFO) and Last-In, First-Out (LIFO) are two primary methods for valuing inventory and calculating the Cost of Goods Sold (COGS). The choice between them significantly impacts a company's financial statements and tax liability, especially in fluctuating price environments. This guide breaks down how each method works and why it matters.

First-In, First-Out (FIFO): Selling the Oldest First

What is FIFO?

The FIFO method assumes that the first units purchased are the first ones sold. This cost flow assumption generally matches the actual physical flow of goods for most businesses, especially those dealing with perishable items (like groceries) or products with a life cycle (like electronics).

FIFO Example

Imagine a company makes the following purchases:

• Jan 1: Buys 100 units @ $10/unit
• Feb 1: Buys 100 units @ $12/unit

It then sells 120 units.

Under FIFO:

The Cost of Goods Sold (COGS) is calculated using the oldest costs first:
(100 units * $10) + (20 units * $12) = $1,240.

The Ending Inventory consists of the most recently purchased units:
(80 units * $12) = $960.

Impact of FIFO on Financials

FIFO's impact depends heavily on price trends.

During Rising Prices (Inflation):

• Lower COGS: Matches older, cheaper costs against current revenues.
• Higher Gross Profit & Net Income: Leads to a higher reported profit.
• Higher Tax Liability: More profit means more taxes.
• Higher Ending Inventory Value: Inventory on the balance sheet reflects recent, higher prices, providing a more accurate view of current replacement cost.

During Falling Prices (Deflation):

• Higher COGS: Matches older, more expensive costs against revenues.
• Lower Gross Profit & Net Income: Results in lower reported profit.
• Lower Tax Liability: Less profit means less taxes.
• Lower Ending Inventory Value: Balance sheet reflects cheaper recent costs.

Last-In, First-Out (LIFO): Selling the Newest First

What is LIFO?

The LIFO method assumes that the last units purchased are the first ones sold. This cost flow rarely matches the actual physical flow of goods but is used for its tax advantages during periods of inflation.

Important Note: LIFO is permitted under U.S. GAAP but is prohibited by International Financial Reporting Standards (IFRS).

LIFO Example

Using the same data as before:

• Jan 1: Buys 100 units @ $10/unit
• Feb 1: Buys 100 units @ $12/unit

It then sells 120 units.

Under LIFO:

The Cost of Goods Sold (COGS) is calculated using the newest costs first:
(100 units * $12) + (20 units * $10) = $1,400.

The Ending Inventory consists of the oldest purchased units:
(80 units * $10) = $800.

Impact of LIFO on Financials

LIFO's impact is generally the opposite of FIFO's.

During Rising Prices (Inflation):

• Higher COGS: Matches recent, more expensive costs against current revenues (better matching principle).
• Lower Gross Profit & Net Income: Leads to a lower reported profit.
• Lower Tax Liability: This is the primary reason companies use LIFO.
• Lower Ending Inventory Value: Inventory on the balance sheet can be severely understated ("LIFO reserve"), as it reflects old, outdated costs.

During Falling Prices (Deflation):

• Lower COGS: Matches recent, cheaper costs against revenues.
• Higher Gross Profit & Net Income: Results in higher reported profit.
• Higher Tax Liability: Eliminates the tax advantage.
• Higher Ending Inventory Value: Balance sheet reflects older, more expensive costs.

FIFO vs. LIFO: A Head-to-Head Comparison

Attribute	First-In, First-Out (FIFO)	Last-In, First-Out (LIFO)
Cost Flow Assumption	Oldest costs are expensed first as COGS.	Newest costs are expensed first as COGS.
Income Statement (Inflation)	Reports higher net income because COGS is lower.	Reports lower net income because COGS is higher.
Balance Sheet (Inflation)	Ending inventory value is closer to current market value.	Ending inventory value can be significantly understated.
Tax Impact (Inflation)	Results in a higher tax liability.	Results in a lower tax liability (tax deferral).
Regulatory Acceptance	Permitted by both U.S. GAAP and IFRS.	Permitted by U.S. GAAP only; prohibited by IFRS.
Matching Principle	Poorly matches current costs with current revenues.	Better matches current costs with current revenues.

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