FIFO vs LIFO: Differences, Examples and Where LIFO Is Allowed

TL;DR: FIFO (first in, first out) assumes the oldest stock is sold first; LIFO (last in, first out) assumes the newest stock is sold first. When purchase prices rise, FIFO shows lower cost of goods sold, higher profit and a higher closing inventory; LIFO shows the opposite and defers tax. LIFO is allowed only in the US: IFRS (IAS 2), UK GAAP (FRS 102) and Indian standards (AS 2, Ind AS 2) permit FIFO or weighted average, not LIFO.

FIFO vs LIFO is a choice of cost flow assumption: which purchase cost you attach to the units you sold, and which you leave in closing stock. It does not have to match how goods physically move in the warehouse. The choice changes three numbers on your accounts: cost of goods sold (COGS), gross profit and the value of inventory on the balance sheet. With prices flat, both methods give the same answer. With prices moving, they split, and the gap grows with inflation and with how slowly your stock turns.

What does first in, first out (FIFO) mean?

FIFO (first in, first out) is an inventory costing method that charges the cost of the earliest purchases to COGS first, so the units left in closing inventory carry the most recent prices. Most businesses use it because it matches how most stock really moves (oldest units out first, especially for food, cosmetics, medicines and anything with a shelf life) and because it is accepted everywhere: under US GAAP, IFRS, UK FRS 102 and Indian accounting standards.

In the US, IRS Publication 538 treats FIFO as the default: if you do not elect another method, your inventory is costed on the FIFO basis.

Advantages and disadvantages of FIFO

• Advantage: closing inventory on the balance sheet sits close to current replacement cost, so the balance sheet is more realistic.
• Advantage: accepted by every major framework, so no restatement when you raise funds, sell abroad or report to a parent in another country.
• Advantage: simple to explain to auditors, lenders and staff.
• Disadvantage: in a period of rising prices, FIFO reports higher profit, so you pay more income tax now.
• Disadvantage: reported gross margin can look better than your current economics, because old cheap stock is matched against today's selling price.

How does last in, first out (LIFO) work?

LIFO (last in, first out) is an inventory costing method that charges the cost of the most recent purchases to COGS first, so closing inventory carries the oldest prices. The US Internal Revenue Code defines it in section 472(b)(1): goods on hand at year end are treated as "first, those included in the opening inventory... and second, those acquired in the taxable year". Put the other way round, what you sold is assumed to be what you bought most recently.

Advantages and disadvantages of LIFO

• Advantage: in inflation, COGS reflects current costs, so taxable profit is lower and tax is deferred.
• Advantage: gross margin reflects what it costs to replace stock today.
• Disadvantage: closing inventory can be valued at prices from years or decades ago, which understates assets.
• Disadvantage: not allowed outside the US, and in the US it comes with the conformity rule and a formal election (both below).
• Disadvantage: if stock levels fall, old low-cost layers flow into COGS (a "LIFO liquidation") and profit and tax jump in that year.

FIFO vs LIFO: what is the difference?

The difference between FIFO and LIFO is which cost goes to the income statement and which stays on the balance sheet. This table summarises it for a period of rising purchase prices.

When prices fall, every "highest" and "lowest" in the first five rows swaps.

The choice also moves the ratios that lenders and investors read. Because LIFO carries a smaller inventory figure, a LIFO company shows a lower current ratio (current assets divided by current liabilities) and a higher inventory turnover ratio (COGS divided by average inventory) than an identical FIFO company. Analysts comparing a LIFO retailer with an IFRS competitor add the disclosed LIFO reserve back to inventory before comparing working capital, days of stock or return on assets. Cash is the one thing the method changes in real terms: under LIFO in inflation, lower taxable income means lower tax payments, so operating cash flow is higher even though reported earnings are lower.

How do you calculate FIFO and LIFO? A worked example

Calculating COGS under FIFO or LIFO means walking through your purchase layers in order. Take a shop that starts the year with no stock of one item and buys three lots:

During the year it sells 180 units at $25.00 each, so revenue is $4,500.00. It has 120 units left.

Example of calculating FIFO COGS

FIFO takes the oldest layers first:

• 100 units from 5 January at $10.00 = $1,000.00
• 80 units from 10 March at $12.00 = $960.00
• FIFO COGS = $1,960.00
• Closing inventory = 20 units at $12.00 + 100 units at $15.00 = $240.00 + $1,500.00 = $1,740.00
• Gross profit = $4,500.00 - $1,960.00 = $2,540.00 (56.4% gross margin)

Example of calculating LIFO COGS

LIFO takes the newest layers first:

• 100 units from 15 June at $15.00 = $1,500.00
• 80 units from 10 March at $12.00 = $960.00
• LIFO COGS = $2,460.00
• Closing inventory = 20 units at $12.00 + 100 units at $10.00 = $240.00 + $1,000.00 = $1,240.00
• Gross profit = $4,500.00 - $2,460.00 = $2,040.00 (45.3% gross margin)

Weighted average cost (WAC) example

Weighted average cost divides total cost by total units: $3,700.00 / 300 = $12.33 per unit (to the cent; keep full precision in the calculation).

• COGS = 180 x $12.333 = $2,220.00
• Closing inventory = 120 x $12.333 = $1,480.00
• Gross profit = $2,280.00 (50.7% gross margin)

Checking your work

In every method, COGS plus closing inventory must equal the cost of goods available: $1,960 + $1,740, $2,460 + $1,240 and $2,220 + $1,480 all equal $3,700. If your numbers do not tie, a layer was skipped or counted twice.

The FIFO and LIFO gross profits differ by $500.00. At the 21% US federal corporate rate, that is $105.00 of tax deferred by LIFO this year on a single item. That $500.00 also equals the gap between FIFO and LIFO closing inventory ($1,740 - $1,240), which is what US companies disclose as the LIFO reserve.

To turn COGS into margin, plug the revenue and cost into the gross margin calculator.

How do inflation and deflation change the result?

Inflation is what makes the choice matter. When each new lot costs more than the last, LIFO pushes the expensive lots into COGS, lowers profit and lowers tax; FIFO pushes the cheap lots into COGS and raises both. In deflation, for example electronics whose purchase price falls every quarter, the effect reverses: FIFO gives the lower profit and LIFO the higher.

Two more effects to watch:

1. Turnover. If you sell your whole stock every few weeks, the layers are close in price and the methods barely differ. Slow-moving stock (spare parts, hardware, wine) shows the biggest gap.
2. LIFO liquidation. A LIFO business that lets stock run down eats into layers bought at old, low prices. COGS falls and profit rises sharply in that year, which is why LIFO users track layers year by year.

Is LIFO allowed? The rules by country

LIFO is allowed for financial reporting only under US GAAP, and for tax only by the US Internal Revenue Service. Everywhere else, the standards limit you to FIFO, weighted average or specific identification.

United States: IRS rules, Form 970 and the conformity rule

• Election: you adopt LIFO by filing Form 970, Application to Use LIFO Inventory Method, with your income tax return for the first year you use it (IRC section 472(a)).
• Conformity rule: section 472(c) lets you use LIFO for tax only if you also use it in reports to shareholders, partners or other owners and "for credit purposes". You cannot show lenders FIFO profit and the IRS LIFO profit.
• Opening stock: the opening inventory of the first LIFO year is valued at cost, and any resulting change is spread evenly over 3 tax years (section 472(d)).
• Staying on LIFO: once adopted, you must keep using it unless the IRS approves a change (section 472(e)); a change of method is requested on Form 3115.
• Variants: IRS Publication 538 also describes dollar-value LIFO and simplified dollar-value LIFO, which group items into pools and use price indexes instead of tracking every unit.

IFRS: IAS 2

IAS 2 Inventories, as revised in 2003 and effective from 1 January 2005, lets companies assign cost using FIFO or the weighted average cost formula, with specific identification for items that are not interchangeable. LIFO is not in the list, so a company reporting under IFRS cannot use it, even if it is a subsidiary of a US group that does.

United Kingdom: FRS 102 and HMRC

HMRC's Business Income Manual (BIM33120) states that FRS 102 Section 13 Inventories prohibits LIFO. For tax, HMRC accepts stock valued at the lower of cost and net realisable value, or mark to market (BIM33115). The leading case is Minister of National Revenue v Anaconda American Brass Ltd [1956], a Privy Council decision on a Canadian metals company that had used LIFO during the 1947 price rise; the court held LIFO did not reflect the company's true profit.

India: AS 2 and Ind AS 2

Indian accounting standards follow the same rule as IAS 2. AS 2 (Valuation of Inventories) and Ind AS 2 allow FIFO or weighted average cost, and specific identification for goods not ordinarily interchangeable. LIFO is not permitted, so an Indian business choosing between FIFO and LIFO is really choosing between FIFO and weighted average.

FIFO or LIFO: which method should a small business use?

FIFO is the right default for most small businesses. Use this decision list:

1. You report under IFRS, UK GAAP or Indian GAAP, or you might sell or raise money abroad: FIFO or weighted average. LIFO is not an option.
2. You sell perishable or dated goods: FIFO, because the cost flow then matches the physical flow and your stock records stay easy to audit.
3. You buy the same commodity at volatile prices and hold lots of interchangeable units (fuel, grain, bulk metals): weighted average smooths the swings without LIFO's restrictions.
4. You are a US business with large, slow-turning inventory in an inflationary market, and you accept the conformity rule: LIFO can defer a meaningful amount of tax. Model it with your accountant before filing Form 970, because getting off LIFO later needs IRS consent.
5. Each item is unique (cars by VIN, jewellery, artwork): specific identification, which charges each item's own cost.

Whichever you choose, apply it consistently. Switching methods to flatter one year's profit is exactly what auditors and tax authorities look for.

How do I keep the records FIFO or LIFO needs?

Any cost flow method needs a record of each purchase lot (date, quantity, unit cost) and each sale or issue. In practice that means a stock register or a stock ledger where every unit in and out is a dated line linked to the purchase bill or sales invoice that caused it, plus periodic counts that reconcile the book quantity to what is on the shelf. LuckPanda's Inventory module is being built around exactly this: stock movements that each carry a date, a quantity and the document behind them. Until then, a spreadsheet with one row per lot works for a few dozen items.

Related reading: how purchase requisitions work and the blanket purchase order guide for the buying side of the same records.