FIFO vs LIFO: Inventory Accounting Explained

FIFO (first-in, first-out) and LIFO (last-in, last-out) are the two main accounting methods for deciding which unit costs move from inventory to cost of goods sold when a company sells something. Neither method has anything to do with which physical items actually leave the warehouse first — it’s purely about which cost figure gets used in the accounting. Picking one over the other can materially change a company’s reported profit, tax bill, and balance sheet, even when the number of units sold is identical.

The problem both methods solve

Inventory costs aren’t static. A retailer that bought widgets at $10 apiece last quarter and $14 apiece this quarter has two different costs sitting in inventory for what are, functionally, identical items. When a widget sells, the accountant has to decide: does this sale get costed at $10 or $14? FIFO and LIFO are two consistent rules for answering that question across every sale, so the number isn’t picked case by case.

How FIFO works

FIFO assumes the oldest inventory costs are used up first. If a company bought 100 units at $10 and later 100 units at $14, and then sells 120 units, FIFO costs the first 100 at $10 and the remaining 20 at $14 — a total cost of goods sold of $1,280. The units still in inventory are valued at the most recent, higher cost ($14), which tends to keep the balance sheet’s inventory value closer to current replacement cost.

How LIFO works

LIFO assumes the newest inventory costs are used up first. In the same scenario, the 120 units sold would be costed as 100 units at $14 and 20 units at $10 — a total cost of goods sold of $1,600. The inventory left on the books is valued at the older, lower cost, which can understate the balance sheet’s inventory value the longer prices keep rising.

Why the choice moves the numbers

During a period of rising prices, LIFO pushes higher, more recent costs into cost of goods sold, which lowers reported gross profit and, in turn, taxable income. FIFO does the opposite — it leaves the cheaper, older costs in cost of goods sold, which inflates reported profit relative to LIFO during the same inflationary stretch. Neither number is “wrong”; they’re different but equally valid accounting representations of the same underlying sales.

This is also why the choice affects working capital and liquidity ratios like the current and quick ratios: a lower LIFO inventory value on the balance sheet makes a company’s current assets look smaller than a FIFO valuation of the identical physical inventory would.

The rule that locks the choice in

In the United States, a company that elects LIFO for tax reporting must also use LIFO in its financial statements — the LIFO conformity rule prevents a company from claiming the lower tax bill from LIFO while showing shareholders the higher profit FIFO would produce. This rule is a big reason LIFO adoption is concentrated in industries with genuinely rising input costs, like energy and industrial materials, where the tax benefit is worth the accounting complexity.

International Financial Reporting Standards (IFRS) don’t permit LIFO at all — only FIFO and weighted-average cost are allowed. That’s part of why LIFO is largely a US GAAP phenomenon; companies reporting under IFRS don’t have the option in the first place.

FIFO vs LIFO at a glance

	FIFO	LIFO
Cost flow assumption	Oldest costs used first	Newest costs used first
COGS in rising prices	Lower	Higher
Reported profit in rising prices	Higher	Lower
Ending inventory value	Closer to current cost	Can lag current cost significantly
Permitted under IFRS	Yes	No
Common in	Most industries by default	Energy, industrials, other rising-cost sectors

Reading it from the outside

As an outside reader of financial statements, the method a company uses matters most when comparing across companies or across time. A company that switches from FIFO to LIFO (or the reverse) will show a profit change that has nothing to do with operations — it’s purely a reporting artifact. The footnotes to a 10-K disclose which method a company uses and, for LIFO filers, often a “LIFO reserve” figure that lets you approximate what inventory and cost of goods sold would look like under FIFO instead, which is the cleanest way to compare a LIFO company against FIFO peers.

The takeaway

FIFO and LIFO are both legitimate ways to cost inventory that’s identical in reality but was bought at different prices over time — the choice doesn’t change what happened, only how it’s reported. FIFO tends to show higher profit and a more current inventory value when prices rise; LIFO shifts the opposite way and lowers the tax bill in the same conditions, which is exactly why the conformity rule exists to keep the choice consistent between tax and financial reporting.