The main inventory costing methods are first-in first-out (FIFO), last-in first-out (LIFO), weighted-average cost, and specific identification. Each is a rule for deciding which costs flow to cost of goods sold when you sell a unit and which costs stay on the balance sheet as ending inventory. The physical goods can move any way you like; these inventory costing methods govern the accounting cost that follows them, and that choice drives reported profit, ending inventory, and, in the case of LIFO, the tax you actually pay.
Quick answer: FIFO expenses your oldest costs first, so during inflation it produces lower cost of goods sold, higher profit, and higher ending inventory (and higher tax). LIFO expenses your newest costs first, so during inflation it produces higher cost of goods sold, lower profit, and a tax deferral, though it is barred under IFRS and comes with a strict conformity rule for tax use. Weighted-average blends all costs into one rate and lands between the two. Specific identification tracks the exact cost of each individual item and suits high-value, low-volume goods. Choose based on how prices are moving, your tax posture, your reporting framework, and how identifiable your units are.
The Four Inventory Costing Methods, Defined
FIFO assumes the first units you bought are the first units you sell. The cost of goods sold reflects your oldest purchase costs, and ending inventory reflects your most recent purchase costs. For most businesses this mirrors the real physical flow of goods, especially anything perishable or subject to obsolescence, which is part of why FIFO is the most widely used method.
LIFO assumes the last units you bought are the first units you sell. Cost of goods sold reflects your newest, most recent costs, and ending inventory carries your oldest costs. LIFO rarely matches physical flow, and it is a distinctly U.S. phenomenon: it is permitted under U.S. tax law and U.S. GAAP but prohibited under International Financial Reporting Standards, which the IFRS Foundation confirms in IAS 2. That makes LIFO unavailable to companies that report under IFRS.
Weighted-average cost pools the cost of all available units and divides by the number of units to produce a single average cost per unit. Every sale and every unit of ending inventory carries that same blended cost until the next purchase changes the average. In a perpetual system this is often called the moving-average method because the average recalculates after each purchase.
Specific identification tracks the actual, individual cost of each unit sold and each unit remaining. It is the most precise method, but it is only practical when items are unique and separately identifiable, such as automobiles, jewelry, real estate, or serialized machinery. For a distributor moving thousands of interchangeable SKUs, specific identification is unworkable, which is why the cost-flow assumptions exist in the first place.
How Each Method Affects COGS, Ending Inventory, and Taxes
Costing methods only diverge when unit costs change over time. If your purchase price never moved, FIFO, LIFO, and weighted-average would all report identical numbers. The differences below all trace back to one variable: the direction and size of price changes across your inventory purchases.
Consider a simple illustration. Suppose you buy 100 units at $10 in January, 100 units at $12 in June, and 100 units at $14 in November, then sell 200 units during the year. Under FIFO, cost of goods sold is the first 200 units: (100 x $10) + (100 x $12) = $2,200, and ending inventory is the remaining 100 units at $14 = $1,400. Under LIFO, cost of goods sold is the last 200 units: (100 x $14) + (100 x $12) = $2,600, and ending inventory is 100 units at $10 = $1,000.
Under weighted-average, the average cost is $3,600 total cost divided by 300 units, or $12 per unit. Cost of goods sold is 200 x $12 = $2,400, and ending inventory is 100 x $12 = $1,200. Notice the pattern: in this rising-price scenario, FIFO reports the lowest cost of goods sold and highest inventory, LIFO reports the highest cost of goods sold and lowest inventory, and weighted-average sits between them.
Those cost-of-goods-sold figures flow straight through to pretax income and therefore to tax. Higher cost of goods sold means lower taxable income, so during inflation LIFO produces the lowest current tax bill, FIFO the highest, and weighted-average the middle. The dollars are the same $3,600 of total cost either way; the methods only differ in the timing of when that cost is recognized as expense.
Now flip the scenario. In a deflationary period, when your unit costs are falling, the results invert. FIFO expenses the older, higher costs first and produces higher cost of goods sold, lower profit, and lower tax, while LIFO expenses the newer, lower costs first and produces lower cost of goods sold, higher profit, and higher tax. The rule of thumb is that FIFO and LIFO trade places depending on whether prices are rising or falling, and weighted-average always lands in the middle because it dampens both movements.
The Tax Angle: LIFO, the Conformity Rule, and GAAP
LIFO’s appeal is almost entirely a tax story. During sustained inflation it defers income tax by matching your newest, highest costs against current revenue, keeping cash in the business rather than sending it to the IRS. The deferral is real but not permanent; it reverses if inventory quantities later decline and you are forced to sell from old, low-cost layers, an event known as LIFO liquidation that can spike taxable income in a single year.
The most important string attached is the LIFO conformity rule under Internal Revenue Code Section 472(c). A taxpayer that uses LIFO for tax purposes must also use LIFO in the income statements it issues to shareholders, creditors, and other external parties. In practice this means you cannot show lenders and investors the higher earnings that FIFO or average cost would report while claiming the lower LIFO income on your tax return; the IRS requires a taxpayer to elect LIFO by filing Form 970, and the conformity requirement follows that election.
That trade-off matters for any business with loan covenants, bonding requirements, or a sale on the horizon, because LIFO depresses both reported earnings and reported inventory. A manufacturer weighing LIFO in a tariff-driven cost environment should read our deeper analysis of the LIFO election and the liquidation trap before filing, since the timing of the election is where most of the planning value sits.
On the GAAP side, all four methods are acceptable, but the measurement rules that sit on top of them differ. Under FASB Accounting Standards Update 2015-11, most companies now measure inventory at the lower of cost and net realizable value, but that simplification specifically excludes inventory measured using LIFO or the retail inventory method, which remain on the older lower-of-cost-or-market test. So the costing method you pick also determines which subsequent-measurement rule applies to writedowns.
One further GAAP disclosure point applies to LIFO users. Companies on LIFO must disclose the LIFO reserve, the difference between LIFO inventory and what inventory would have been under FIFO or average cost, so financial statement readers can compare across companies that use different methods. That disclosure is why an analyst can back out the LIFO effect even though the conformity rule forces LIFO onto the face of the statements.
How to Choose the Right Method
Start with your reporting framework. If your company reports or expects to report under IFRS, LIFO is off the table entirely, which narrows the field to FIFO, weighted-average, and specific identification before any other analysis. Companies that only report under U.S. GAAP keep all four options open.
Next, look at how your costs are moving and how much inventory you carry. FIFO tends to fit businesses with perishable or fast-turning goods, and it produces a balance sheet inventory figure close to current replacement cost, which many lenders and readers prefer. LIFO tends to fit capital-intensive manufacturers and distributors with large, stable inventories facing persistent input-cost inflation, where the tax deferral is large enough to justify the recordkeeping and the conformity constraint.
Weighted-average is the pragmatic middle choice, and it is often the default in ERP systems because it smooths price volatility and avoids tracking individual layers. It works well for commodity-like inventory where units are interchangeable and no single method offers a decisive tax or reporting edge. Specific identification is reserved for high-value, individually identifiable items where tracking the exact cost of each unit is both feasible and meaningful.
Consistency is the final constraint. Accounting standards expect you to apply a chosen method consistently from period to period, and changing methods for tax purposes generally requires IRS consent through an accounting method change on Form 3115. Distributors managing this alongside working-capital and margin pressures can review our distribution industry resources, and manufacturers can see how method selection ties into broader planning through our manufacturing practice. The right method is the one that fits your cost trend, your tax strategy, your reporting obligations, and the nature of the goods you actually sell.
Frequently Asked Questions
What are the main inventory costing methods?
The four main inventory costing methods are FIFO (first-in, first-out), LIFO (last-in, first-out), weighted-average cost, and specific identification. FIFO and LIFO are cost-flow assumptions that expense your oldest or newest costs first; weighted-average blends all costs into a single per-unit rate; and specific identification tracks the actual cost of each individual unit. All four are permitted under U.S. GAAP, but LIFO is prohibited under IFRS.
Which inventory method is best during inflation?
During inflation, LIFO produces the highest cost of goods sold and the lowest taxable income, which defers tax and preserves cash. FIFO does the opposite, reporting higher profit and higher inventory value but a larger current tax bill. Whether LIFO is worth it depends on whether the tax deferral outweighs the conformity rule, the recordkeeping burden, and the risk of a future LIFO liquidation.
Is LIFO allowed under GAAP and IFRS?
LIFO is permitted under U.S. GAAP and U.S. tax law but is prohibited under IFRS, per IAS 2. Companies that report under IFRS must use FIFO, weighted-average, or specific identification. This difference is one reason LIFO is used almost exclusively by U.S. taxpayers.
What is the LIFO conformity rule?
The LIFO conformity rule, under Internal Revenue Code Section 472(c), requires a taxpayer that uses LIFO for tax purposes to also use LIFO in the financial statements it issues to shareholders and creditors. You cannot report higher FIFO or average-cost earnings to lenders while claiming lower LIFO income to the IRS. This book-tax conformity requirement can affect loan covenants, bonding, and investor perception.
How does weighted-average cost work?
Weighted-average cost divides the total cost of goods available for sale by the total number of units available to produce a single average cost per unit. That average is applied to both units sold and units remaining in ending inventory. In a perpetual inventory system the average recalculates after each purchase, which is why it is often called the moving-average method.
Can a company change its inventory costing method?
Yes, but not freely. Accounting standards require consistent application of a chosen method, and changing methods for federal tax purposes generally requires IRS consent through an accounting method change filed on Form 3115. A change also has to be disclosed and, in financial reporting, may need to be applied retrospectively, so most companies change methods only for a substantive business or tax reason.
