What it means
A hardware store bought 100 identical bolts in January at $1.00 and 100 more in June at $1.20. It sold 150 during the year.
Which bolts did it sell, and what did they cost? Physically, nobody knows and nobody cares; the bolts are interchangeable.
But the accounts must assign a cost to the 150 sold and to the 50 left, and the total is fixed ($220): the question is how to split it. That is the cost flow assumption.
FIFO assumes the first bolts bought were the first sold: 100 at $1.00 and 50 at $1.20, cost of goods sold $160, closing inventory 50 at $1.20 = $60. LIFO assumes the last bought were the first sold: 100 at $1.20 and 50 at $1.00, cost of goods sold $170, closing inventory 50 at $1.00 = $50.
Weighted average: 200 bolts cost $220, $1.10 each; cost of goods sold $165, inventory $55. The total is $220 under all three; the split differs, and with it the year's profit and the balance sheet.
When prices rise, FIFO gives the lowest cost of goods sold and highest profit (old, cheap costs go to the income statement) and the highest inventory value (new, expensive costs stay on the balance sheet, close to current replacement cost). LIFO gives the highest cost of goods sold and lowest profit (new, expensive costs go to the income statement, matching current costs with current revenues) and the lowest inventory value (old costs accumulate on the balance sheet, which after years of inflation can be far below replacement cost).
Weighted average sits between. When prices fall, the effects reverse.
The choice has consequences beyond the arithmetic. Tax: in the United States, a company that uses LIFO for tax must use it for financial reporting (the conformity rule), and in inflationary periods LIFO reduces taxable income and defers tax; the cumulative deferral (the LIFO reserve, the difference between LIFO and FIFO inventory) can be large for long-established companies.
Comparability: two identical companies using different assumptions report different profits and inventory, and analysts adjust LIFO companies to a FIFO basis using the disclosed reserve. LIFO liquidation: if a LIFO company's inventory falls, old low-cost layers are released into cost of goods sold, producing a profit that reflects decades-old prices rather than current performance, which is why LIFO companies try to avoid reducing inventory at year end.
Balance sheet relevance: LIFO inventory values can be meaningless as a measure of what the inventory is worth. IFRS prohibits LIFO on the grounds that it does not represent the actual flow of inventory and produces balance sheet values that are not current.
Companies reporting under IFRS use FIFO or weighted average, and must use the same method for all inventories of similar nature and use. Weighted average is common in process industries and for commodities where units are fungible and continuously mixed; FIFO where inventory is physically rotated (perishables) or where management wants inventory near current cost.
Specific identification is used for cars, jewellery, real estate lots, and other items that are individually tracked, and it is the only method that reflects actual cost flow. The assumption, once chosen, is an accounting policy applied consistently; a change is a change in accounting principle, applied retrospectively with disclosure.
In practice
Real-world examples.
Example
A US oil refiner uses LIFO, carrying inventory bought decades ago at a fraction of current prices, with a LIFO reserve of $2 billion disclosed in its notes.
Example
A European supermarket uses FIFO, matching its physical rotation of perishable stock, so that inventory is valued near current cost.
Example
A copper wire manufacturer uses weighted average because its raw material is continuously blended and units cannot be distinguished.
Think of it
“Cost flow assumption decides which costs leave with sold goods versus stay in inventory.
Formula
Calculation
Cost of Goods Available for Sale = Opening inventory + Purchases (at cost)
Cost of Goods Sold + Closing Inventory = Cost of goods available (under any assumption)
FIFO: Closing inventory = Most recent purchases; COGS = Oldest costs
LIFO: Closing inventory = Oldest costs; COGS = Most recent purchases
Weighted average (periodic): Average cost = Cost of goods available / Units available; COGS = Units sold x Average; Closing inventory = Units on hand x Average
LIFO Reserve = FIFO inventory minus LIFO inventory; FIFO-basis profit = LIFO profit + Increase in LIFO reserve
Worked example. A building materials merchant's purchases and sales of a grade of timber during a year of rising prices:
- Opening inventory: 2,000 units at $50 = $100,000
- March purchase: 3,000 units at $55 = $165,000
- July purchase: 4,000 units at $62 = $248,000
- October purchase: 2,000 units at $68 = $136,000
- Available: 11,000 units, $649,000
- Sold during the year: 8,500 units at an average price of $90 = $765,000 revenue
- Closing inventory: 2,500 units
FIFO: closing inventory is the newest 2,500 units: 2,000 at $68 + 500 at $62 = $136,000 + $31,000 = $167,000. COGS = $649,000 minus $167,000 = $482,000. Gross profit = $765,000 minus $482,000 = $283,000 (37.0%).
LIFO (periodic): closing inventory is the oldest 2,500 units: 2,000 at $50 + 500 at $55 = $100,000 + $27,500 = $127,500. COGS = $649,000 minus $127,500 = $521,500. Gross profit = $243,500 (31.8%).
Weighted average: $649,000 / 11,000 = $59.00 per unit. Closing inventory = 2,500 x $59.00 = $147,500. COGS = 8,500 x $59.00 = $501,500. Gross profit = $263,500 (34.4%).
Comparison: same physical transactions, gross profit ranging from $243,500 to $283,000, a difference of $39,500 (16% of the LIFO figure). At a 25% tax rate, LIFO saves $9,875 of tax this year compared with FIFO. LIFO reserve at year end = $167,000 minus $127,500 = $39,500; an analyst converting the LIFO company to FIFO adds it to inventory and, if the reserve grew by $39,500 in the year from nil, adds $39,500 to pre-tax profit.
Replacement cost check: the current purchase price is $68; the 2,500 units would cost $170,000 to replace. FIFO inventory ($167,000) approximates it; LIFO ($127,500) understates it by 25%; after ten years of inflation the gap would be far larger.
LIFO liquidation: the following year, the merchant reduces its stock to 500 units. Under LIFO, 2,000 units of the $50 layer are released into cost of goods sold at $50 when the current price is $72: an extra $44,000 of profit that reflects the liquidation of an old layer, not the year's trading. The company discloses the liquidation effect so that readers do not mistake it for margin improvement.
Falling prices: had the year's purchase prices fallen from $68 to $50 instead, FIFO would give the highest COGS and lowest profit, and LIFO the reverse; and under both, the closing inventory would be tested against net realisable value and written down if the selling price had fallen below cost.Case study
Seen in the real world.
A US chemicals distributor had used LIFO since the 1970s, accumulating a LIFO reserve of $60,000,000 on inventory carried at $40,000,000 (FIFO value $100,000,000). The deferral had saved tens of millions in tax over the decades, and each year's management accounts, prepared on FIFO for operational purposes, showed a healthy inventory value that the audited accounts did not. When the company was put up for sale, buyers valued it on the audited figures and asked why inventory was so low relative to sales; when they understood, they priced the deferred tax liability that would crystallise if LIFO were ever abandoned (the company's acquisition by an IFRS-reporting buyer would require it) at about $15,000,000.
In the year before the sale, a supply disruption forced the company to run inventory down by 30%, releasing $18,000,000 of old LIFO layers into profit; the reported margin jumped from 8% to 11% and the tax bill with it, undoing part of the deferral in a single year. The finance director's summary for the buyer was that LIFO had been a good tax policy for forty years and a poor description of the business for every one of them, and that the two facts had finally met.
Watch out
Common mistakes.
- Assuming the cost flow assumption must match the physical flow of goods. It need not; it is an accounting convention, and only specific identification tracks actual units.
- Comparing the profits or inventory of a LIFO company with a FIFO company without adjusting for the LIFO reserve.
- Allowing a LIFO company's inventory to fall at year end without recognising the liquidation effect on profit and tax.
Questions
People also ask.
Which method gives the highest profit?
In rising prices, FIFO (old costs in cost of goods sold); in falling prices, LIFO. Weighted average is between. Over the life of the inventory the totals are the same; only timing differs.
Why does IFRS prohibit LIFO?
Because it rarely reflects the actual flow of goods and produces inventory values that can be far from current cost, reducing the relevance of the balance sheet. US GAAP permits it largely for tax reasons.
Can a company change its cost flow assumption?
Yes, as a change in accounting principle, justified by improved relevance, applied retrospectively with restatement and disclosure. US companies using LIFO for tax face conformity rules and a tax charge on the reserve if they change.
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