Master Inventory Accounting: Key Differences in Weighted Average, FIFO, LIFO

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Weighted average cost, FIFO and LIFO are three ways to assign purchase costs to the units a business sells and the units it still holds. Weighted average gives every unit the same blended cost. FIFO (first in, first out) charges the oldest costs to cost of goods sold (COGS) first. LIFO (last in, first out) charges the newest costs first. The physical goods can be identical in all three cases. What changes is which dollar amounts land on the income statement and which stay on the balance sheet. When purchase prices are rising, FIFO reports the lowest COGS and the highest profit, LIFO reports the highest COGS and the lowest profit, and weighted average falls in between. When prices fall, that order reverses.

How each method assigns cost

Weighted average cost

The weighted average method treats all units available for sale as one pool. To get the cost per unit, divide the cost of goods available for sale (beginning inventory plus purchases) by the number of units available for sale. That single rate prices both the units sold and the units remaining:

Weighted average cost per unit = Cost of goods available for sale ÷ Units available for sale

The method works well when individual units cannot practically be told apart, such as fuel, grain, bulk chemicals or identical small parts. It does not track the cost layers that FIFO and LIFO depend on, so a business cannot use it to tell which purchase a given sale came from.

FIFO

FIFO assumes the earliest purchases are sold first. Each sale removes the oldest remaining cost from inventory and records it in COGS. Ending inventory therefore consists of the most recent purchases, which keeps the balance sheet figure close to current replacement cost.

LIFO

LIFO assumes the most recent purchases are sold first. Current costs go to the income statement, and the oldest costs stay in ending inventory, sometimes for many years. A grocer can physically rotate its oldest stock to the front and still report under LIFO, because the method governs the flow of costs, not the flow of goods.

Worked example: same purchases, three results

Assume a hypothetical retailer starts with no inventory and makes two purchases of an identical product in one period:

• 200 units at $10 = $2,000
• 300 units at $20 = $6,000
• Goods available for sale: 500 units costing $8,000

It sells 300 units at $30 each, for revenue of $9,000. The example uses a periodic system, with costs assigned at period end.

Weighted average: $8,000 ÷ 500 = $16 per unit. COGS is 300 × $16 = $4,800. Ending inventory is 200 × $16 = $3,200.

FIFO: The 300 units sold come first from the 200 at $10 and then from 100 of the units at $20. COGS is $2,000 + $2,000 = $4,000. Ending inventory is the remaining 200 units at $20 = $4,000.

LIFO: The 300 units sold come entirely from the $20 purchase. COGS is 300 × $20 = $6,000. Ending inventory is the original 200 units at $10 = $2,000.

In every row, COGS plus ending inventory equals $8,000. The business bought the same goods and sold them at the same price, yet reported gross profit ranges from $3,000 to $5,000. Costs rose during the period, and each method decides how much of the higher $20 cost reaches the income statement now.

The tax effect follows directly. At an assumed 21% tax rate on this gross profit alone, FIFO’s extra $2,000 of profit over LIFO means $420 more tax for the period. LIFO does not erase that tax. It defers it for as long as the old, low-cost layers stay in inventory. The deferral is a real cash saving in the meantime, which shows up in operating cash flow on the cash flow statement.

Why a business picks one method over another

Weighted average is the simplest to apply when units are interchangeable and purchased often. Averaging dampens sharp price moves, so gross margin is steadier from period to period than under FIFO or LIFO.

FIFO values ending inventory at recent purchase costs, so the balance sheet is closer to what the stock would cost to replace. In rising markets it reports higher earnings, which some companies prefer for lenders and investors. It also tends to match the real flow of perishable or dated goods. When prices are falling, FIFO charges the older, higher costs to COGS, which lowers taxable income.

LIFO matches the latest costs against current revenue. During inflation that means higher COGS, lower reported profit and lower taxes, which acts as a partial hedge against rising input costs. The trade-off is a balance sheet inventory figure that can be far below current cost.

If prices are flat, FIFO and average cost produce nearly the same numbers.

Exceptions that change the answer

Falling prices reverse the ranking

The usual “FIFO means higher profit” rule assumes rising costs. If later purchases are cheaper, LIFO charges the cheap recent costs to COGS and reports the higher profit, while FIFO reports the lower one.

LIFO is a U.S. option, not a global one

IFRS (IAS 2) prohibits LIFO and allows only FIFO, weighted average and, for items that are not interchangeable, specific identification. A company reporting under IFRS cannot use LIFO at all. In the United States, the LIFO conformity rule in the Internal Revenue Code means a business that elects LIFO for tax purposes must also use it in its financial statements to shareholders and creditors, so it cannot report FIFO profits to investors while paying LIFO taxes. U.S. companies on LIFO commonly disclose a LIFO reserve, the difference between inventory at FIFO and at LIFO, which lets analysts restate the figures on a comparable basis.

LIFO liquidation

If a LIFO company sells more than it buys and dips into old layers, those decades-old low costs flow into COGS. Reported profit and taxable income jump, and the deferred tax comes due at once.

Periodic vs. perpetual systems

FIFO gives the same result whether costs are assigned at period end or after every sale. The other two do not. Under a perpetual system, weighted average becomes a moving average, recalculated after each purchase, and LIFO draws from whatever layers exist at the moment of each sale. Both can produce different COGS than the periodic calculation above.

Write-downs

Inventory cannot stay on the books above what it can be sold for. Under U.S. GAAP, FIFO and average cost inventory is carried at the lower of cost and net realizable value, while LIFO inventory uses the lower of cost or market. IFRS applies lower of cost and net realizable value to all inventory.

Specific identification

When each item is distinct and traceable, such as cars, jewelry or custom equipment, a business can record the actual cost of each unit sold. This is the only method that matches physical flow and cost exactly, and it makes the cost flow assumptions above unnecessary.

FAQs

The Bottom Line

Business owners, accountants and investors comparing company results need to know which inventory method sits behind the numbers. The choice changes reported profit, taxes and balance sheet values even when the goods and sales are identical, and the ranking flips when prices fall. U.S. companies can weigh LIFO's tax deferral against a lower inventory figure, while companies reporting under IFRS choose among FIFO, weighted average and specific identification.