FIFO vs. LIFO: Inventory Valuation Methods Compared

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FIFO (first in, first out) assumes the oldest inventory costs are expensed first. LIFO (last in, first out) assumes the newest costs are expensed first. When purchase costs are rising, FIFO reports lower cost of goods sold (COGS), higher profit, higher taxes and a more current inventory balance. LIFO reports higher COGS, lower profit, lower taxes and an inventory figure built from older, cheaper costs.

When costs are flat, both methods give the same numbers. When costs fall, the effects reverse. Outside the United States the choice usually doesn’t exist, because International Financial Reporting Standards (IFRS) prohibit LIFO. U.S. GAAP allows both.

So neither method is “better” in general. FIFO gives a truer balance sheet and usually matches how goods physically move. LIFO matches current costs against current revenue and, in an inflationary period, defers income tax for U.S. companies that can use it.

What FIFO and LIFO Actually Measure

Every company that holds inventory has to split the cost of the goods it had available during a period into two parts: the cost of what it sold and the cost of what it still has. The basic inventory equation ties these together:

Beginning inventory + Net purchases − COGS = Ending inventory

Inventory can sit in three stages: raw materials, work in progress (goods being made but not finished) and finished goods ready for sale. Inventory counts as a current asset because it is expected to turn into cash. For many manufacturers, distributors and retailers it is one of the largest items on the balance sheet.

The total cost of goods available for sale (beginning inventory plus purchases) is a fixed number for the period. The method a company picks doesn’t change that total. It only changes how the total is divided between the income statement (COGS) and the balance sheet (ending inventory). If one method puts more cost into COGS, it must leave less cost in inventory, and the reverse.

That split only matters because the cost of making or buying goods changes over time. Raw materials, labor and overhead costs move constantly, so a unit bought this month may cost more or less than an identical unit bought three months ago. If every unit cost the same, FIFO, LIFO and any other method would produce identical results.

First In, First Out (FIFO)

Under FIFO, the first costs recorded in inventory are the first costs moved to COGS. Ending inventory is valued at the most recent purchase costs.

A simple case: a bakery makes 200 loaves on Monday at $1.00 each and 200 more on Tuesday at $1.20 each. It sells 200 loaves on Wednesday. Under FIFO, Wednesday’s COGS is $200 (200 × $1.00). The 200 loaves left on the shelf are carried at $1.20 each, or $240.

Last In, First Out (LIFO)

Under LIFO, the most recent costs go to COGS first. Ending inventory keeps the oldest costs.

In the same bakery case, Wednesday’s COGS under LIFO is $240 (200 × $1.20). The remaining loaves are carried at $1.00 each, or $200. Physically, the bakery may well have sold Monday’s bread first. LIFO doesn’t care. It only assigns costs.

That distinction answers a common objection to LIFO. A grocery chain can rotate stock so the oldest milk sells first and still use LIFO for its books, because the accounting method is separate from the physical flow. Many companies prefer a method that mirrors physical movement, which favors FIFO, but GAAP doesn’t require the match.

FILO (first in, last out) describes the same ordering as LIFO. If the first unit in is the last one out, the most recent units leave first. The two labels lead to the same cost assignment.

The Other Methods

Two other methods sit alongside FIFO and LIFO:

• Weighted average cost divides the total cost of goods available by the total units available and applies that average to both COGS and ending inventory. Its results fall between FIFO and LIFO when costs move in one direction. IFRS and GAAP both permit it.
• Specific identification tracks the actual cost of each individual item. It suits high-value, distinguishable goods such as cars, jewelry or custom equipment. It isn’t practical for large volumes of interchangeable units.

FIFO vs. LIFO: How Rising Costs Change the Numbers

In an inflationary period, the oldest units in inventory were usually the cheapest, and the newest were the most expensive. That ordering drives every difference between the two methods.

Under LIFO, the newer, more expensive costs go to COGS. Gross profit and net income come out lower. Taxable income is lower too, so the tax bill shrinks. The balance sheet carries inventory at old costs, which may be far below what it would cost to replace those goods today. For a company that has used LIFO for decades, the inventory figure can be badly out of date.

Under FIFO, the older, cheaper costs go to COGS. Reported margins and net income are higher, and so is the tax bill. Ending inventory is carried at recent costs, so the balance sheet figure is closer to current value. The weakness is on the income statement. COGS reflects costs from earlier periods, so reported profit includes a gain from holding inventory while prices rose. Analysts sometimes call this a holding gain or “inventory profit.” It may not repeat once the company has to restock at current prices.

The trade-off is a matching question. LIFO matches recent costs with current revenue, which gives an income statement closer to the economics of replacing what was sold. FIFO gives a balance sheet closer to current value. No single cost flow method gets both statements current at the same time.

The size of the gap depends on how fast costs rise and how much inventory the company holds. A business that turns its inventory every few weeks sees little difference, because its old costs and new costs are close together. A business that holds inventory for many months, during years of high inflation, can see a large one. Historical U.S. inflation rates by year show why the issue drew so much attention in high-inflation decades, though any single company’s input costs can rise or fall faster than the general price level.

Example: FIFO vs. LIFO With Rising Costs

The following hypothetical company sells one product. It uses a periodic inventory system, which assigns costs at the end of the quarter. Its tax rate is assumed to be a flat 25% for illustration.

Beginning inventory and purchases (one quarter)

The company sells 2,400 units at $40 each, for revenue of $96,000. That leaves 600 units on hand. Operating expenses are $15,000.

COGS under each method

• FIFO: the 2,400 units sold take the oldest costs first. That is 500 × $20 ($10,000), plus 1,000 × $22 ($22,000), plus 900 × $25 ($22,500). COGS = $54,500.
• LIFO: the 2,400 units sold take the newest costs first. That is 500 × $28 ($14,000), plus 1,000 × $25 ($25,000), plus 900 × $22 ($19,800). COGS = $58,800.
• Weighted average: $71,000 ÷ 3,000 units = $23.67 per unit (rounded). COGS = 2,400 × $23.67 = $56,800 (computed on the unrounded average).

Ending inventory under each method

• FIFO: the 600 units left carry the newest costs: 100 × $25 ($2,500) plus 500 × $28 ($14,000) = $16,500.
• LIFO: the 600 units left carry the oldest costs: 100 × $22 ($2,200) plus 500 × $20 ($10,000) = $12,200.
• Weighted average: 600 × $23.67 = $14,200.

In each case, COGS plus ending inventory equals the $71,000 of goods available. The method moves cost between the two statements. It doesn’t create or remove any.

Simplified income statement

What the Example Shows

The same quarter, with the same units and the same cash paid to suppliers, produces three different profits.

Tax and cash. LIFO’s pre-tax income is $4,300 lower than FIFO’s. At the assumed 25% rate, that saves $1,075 in tax. Taxes are paid in cash, so the LIFO company keeps $1,075 more cash this quarter even though it reports less profit. Apart from that tax effect, the method choice doesn’t change operating cash flow. The cash flow statement of the LIFO company would show stronger operating cash flow than its lower net income suggests.

Margins. Gross margin is 43.2% under FIFO ($41,500 ÷ $96,000) and 38.8% under LIFO ($37,200 ÷ $96,000). An investor comparing a FIFO company with a LIFO company in the same industry could wrongly conclude that the FIFO company has more pricing power. The difference between revenue and profit here comes from accounting, not from operations.

Inventory turnover. Turnover is COGS divided by average inventory. Under FIFO, average inventory is ($10,000 + $16,500) ÷ 2 = $13,250, and turnover is about 4.1 times. Under LIFO, average inventory is ($10,000 + $12,200) ÷ 2 = $11,100, and turnover is about 5.3 times. LIFO makes inventory appear to move faster because it shrinks the denominator and enlarges the numerator.

Liquidity and leverage. Lower LIFO inventory means lower current assets, a lower current ratio and lower reported equity. Debt covenants tied to these figures can be affected by the method choice alone.

The LIFO reserve. The gap between FIFO and LIFO inventory, $16,500 − $12,200 = $4,300, is the LIFO reserve at the end of this quarter. Because both methods started from the same $10,000 beginning inventory, the reserve here equals the COGS difference. Over many years of rising costs, the reserve accumulates and can grow very large relative to reported inventory.

Tax Implications: Why a Company Would Use LIFO Instead of FIFO

The main reason a U.S. company chooses LIFO is tax. When costs rise, higher COGS means lower taxable income, and the savings compound as long as costs keep rising and inventory levels hold steady or grow.

Several rules shape that benefit.

The LIFO conformity rule. Under the U.S. Internal Revenue Code (Section 472), a taxpayer that uses LIFO for its tax return must also use LIFO in the financial reports it gives to shareholders, creditors and other outside users. A company can’t report low LIFO profit to the IRS and high FIFO profit to investors. This is why LIFO appears in U.S. GAAP financial statements at all, and why the tax decision and the reporting decision are linked.

Election. A business elects LIFO for tax purposes by filing IRS Form 970 with its return. Moving off LIFO, or making other changes in inventory method, generally requires filing Form 3115 to request a change in accounting method.

Deferral, not elimination. The tax saved under LIFO isn’t forgiven. It stays embedded in the LIFO reserve. If the company later sells down its old, low-cost inventory layers, or switches to FIFO, the deferred income comes back into taxable income. A company that holds inventory steady for decades may defer the tax for a very long time. A company that shrinks inventory pays some of it back.

Effect on reported earnings. The cost of LIFO’s tax benefit is lower reported net income and earnings per share. Some management teams and boards prefer the higher figures FIFO produces, especially when compensation, valuation multiples or lending terms depend on earnings. When analysts value a business, they often adjust for this so the method choice doesn’t distort the comparison.

FIFO’s tax disadvantage in a period of rising costs is the mirror image. Reported profit is higher, and so is the tax bill, even though some of that profit is the holding gain described above.

Effects on Financial Reporting and Analysis

GAAP and IFRS

U.S. public companies report under generally accepted accounting principles (GAAP), set by the Financial Accounting Standards Board (FASB). GAAP permits FIFO, LIFO, weighted average and specific identification.

IFRS, issued by the International Accounting Standards Board, governs reporting in the EU and many other jurisdictions. Its inventory standard, IAS 2, prohibits LIFO. Companies reporting under IFRS must use FIFO, weighted average cost, or specific identification where it applies. India’s accounting standards for inventory (Ind AS 2, and AS 2 for companies outside Ind AS) also exclude LIFO, so FIFO is allowed in India while LIFO is not. A multinational with a U.S. parent may use LIFO for some U.S. inventories and FIFO or average cost for its foreign subsidiaries.

Disclosure

Companies must state which inventory method they use in the notes to their financial statements. U.S. companies using LIFO typically disclose the LIFO reserve, or enough information to derive what inventory would be under FIFO or current cost. That disclosure is what makes cross-company comparison possible.

Converting LIFO to FIFO for Analysis

To compare a LIFO company with a FIFO or IFRS company, analysts restate the LIFO company onto a FIFO basis:

• FIFO inventory = LIFO inventory + LIFO reserve
• FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)

When the reserve grows during a year, FIFO COGS is lower than LIFO COGS by the amount of the increase. When the reserve shrinks, FIFO COGS is higher.

The balance sheet adjustment also touches taxes and equity. Restating inventory up by the LIFO reserve raises assets. Under the common analytical simplification, part of that increase is treated as deferred tax (reserve × tax rate), and the rest is added to retained earnings (reserve × (1 − tax rate)).

In the example above, the ending reserve is $4,300. With a 25% rate, the restatement adds $4,300 to inventory, about $1,075 to taxes (owed or deferred, depending on the analyst’s assumption) and $3,225 to equity. These adjustments are standard in financial statement analysis courses and appear in the inventory material of the CFA Level 1 exam.

Record-Keeping

LIFO requires tracking cost layers that may sit untouched on the books for years. Each year of inventory growth adds a new layer at that year’s costs. To manage this, many U.S. LIFO users apply dollar-value LIFO, which groups inventory into pools and measures layers in base-year dollars using price indexes rather than tracking individual items.

FIFO layers turn over continuously, so old costs don’t linger. A company that accumulates inventory or goes through slow periods may still need older purchase records to compute FIFO COGS, although accounting software generally handles this automatically.

Exceptions That Change the Answer

The rule that “LIFO lowers profit and taxes, FIFO raises them” depends on conditions. When any of the following applies, the answer shifts.

Flat or Falling Costs

With stable costs, all methods give the same result.

With falling costs, the effects flip. LIFO then expenses the newer, cheaper costs and reports higher profit and higher taxable income, while FIFO expenses the older, more expensive costs and reports lower profit. A company selling goods whose costs fall over time, such as some electronic components, gains no tax benefit from LIFO.

LIFO Liquidation

If a LIFO company sells more units than it buys in a period, it dips into older layers carried at old costs. Those low costs flow into COGS against current selling prices and inflate gross profit.

A hypothetical illustration using the example company: suppose next quarter its replacement cost is $30 per unit, it buys less than it sells, and it ends up expensing the 500-unit $20 base layer. COGS on those units is $10,000 instead of the $15,000 it would cost to replace them. Pre-tax income rises by $5,000, and the deferred tax on that layer becomes payable.

Liquidations can follow supply disruptions, deliberate inventory reductions or a shrinking business. Analysts watch for them because the extra profit doesn’t come from operations and won’t recur. Companies typically disclose material LIFO liquidation effects.

IFRS or Non-U.S. Reporting

A company reporting under IFRS can’t choose LIFO. For that company, the comparison reduces to FIFO versus weighted average cost, and the LIFO tax argument disappears.

Periodic vs. Perpetual Systems

FIFO gives the same answer whether costs are assigned at the end of the period (periodic) or at each sale (perpetual). The oldest costs are always the oldest.

LIFO doesn’t work that way. Under perpetual LIFO, each sale takes the newest cost on hand at that moment. In the example, if 1,500 units had sold before the June purchase, those sales could not have used the $28 June cost. Perpetual LIFO would then produce lower COGS than the periodic calculation. Textbook problems and real systems can produce different LIFO numbers for this reason alone.

Write-Downs

Neither method lets inventory stay on the books above what it can recover. Under GAAP, inventory measured with FIFO or average cost is carried at the lower of cost and net realizable value. Inventory measured with LIFO or the retail inventory method remains under the older lower-of-cost-or-market test. IFRS uses lower of cost and net realizable value for all inventory.

Because FIFO carries inventory at more recent, higher costs, a FIFO company with goods that become obsolete or lose value can face a larger write-down. That risk falls hardest on businesses holding perishable or fast-aging stock.

Changing From LIFO to FIFO, or FIFO to LIFO

A company can change inventory methods, but it can’t switch back and forth freely. Under GAAP (ASC 250), a change in inventory method is a change in accounting principle. The company must justify it as preferable.

Moving from LIFO to FIFO is generally applied retrospectively. Prior periods presented are restated as if FIFO had always been used, and the cumulative effect on periods before those presented is recorded as an adjustment to the opening balance of retained earnings. For tax purposes, leaving LIFO brings the accumulated reserve into taxable income, although the tax rules typically spread that adjustment over more than one year.

Moving from FIFO to LIFO is usually handled prospectively. Reconstructing historical LIFO layers is generally impracticable, so the existing inventory balance becomes the starting LIFO base layer and no retained earnings adjustment is normally made.

In both directions, the method must be applied consistently once adopted, and the notes must explain the change and its effect.

Which Companies Use FIFO and Which Use LIFO

FIFO fits businesses where old stock loses value: grocers, food producers, pharmaceutical distributors and makers of technology products that become obsolete or degrade in storage. These businesses physically sell the oldest goods first, and FIFO keeps their books consistent with that flow. FIFO is also the default for IFRS reporters that don’t use weighted average, and for any business that prefers simpler records and a balance sheet near current cost.

LIFO appeals to U.S. companies that:

• report under GAAP,
• expect their input costs to keep rising,
• hold large, stable or growing inventories, and
• value the tax deferral more than higher reported earnings.

Examples often cited include car dealerships and oil companies, whose inventories are large and whose costs have historically risen over long periods. Some retailers, distributors and manufacturers of commodity-based products also use LIFO for their U.S. inventories.

A company doesn’t need a single method for everything. It can use LIFO for some U.S. inventory pools and FIFO or average cost elsewhere, provided it discloses this and applies each method consistently.

Choosing Between FIFO and LIFO

For a business deciding which method to adopt, or an analyst deciding how to read the result, the question comes down to a few points:

1. Which rules apply? Under IFRS or Indian standards, LIFO is not an option. Under U.S. GAAP, both are.
2. Which way are costs moving? LIFO helps on taxes only while costs rise. With flat or falling costs, it adds complexity without a tax benefit.
3. Will inventory stay level? A company that expects to shrink inventory risks LIFO liquidations that bring the deferred tax back.
4. Which number matters more? FIFO gives a more current balance sheet and higher reported profit. LIFO gives a more current COGS and better after-tax cash flow while costs rise.
5. What does the business physically do? FIFO mirrors the flow of perishable and obsolescence-prone goods, which simplifies explaining the numbers and spotting write-down risk.

For investors comparing companies, the practical step is the restatement: add back the LIFO reserve, adjust COGS for its change, and compare margins, turnover and returns on the same basis. Without that adjustment, two businesses with identical operations can look meaningfully different, as the example showed with a $3,225 gap in net income from one quarter’s inventory alone.

FAQs

The Bottom Line

Only U.S. companies reporting under GAAP face a real choice, since IFRS and Indian standards rule out LIFO. LIFO pays off only while costs rise and inventory holds steady, because a liquidation brings the deferred tax back, while FIFO suits perishable or fast-aging stock and gives a more current balance sheet. Investors comparing a LIFO company with a FIFO one should restate it using the disclosed LIFO reserve before judging margins, turnover or returns.