Inventory Costing Methods Explained: FIFO vs LIFO vs Weighted Average

You bought the same widget three times this year for $10, $12, and $15. You just sold one. What did it cost you?

There is no single correct answer, and that is not a loophole — it is accounting working as designed. The question is answered by your inventory costing method, and depending on which one you use, that sale just cost you $10, $15, or $12.33. Each is legitimate. Each produces a different gross profit, a different balance sheet, and a different number on your tax return.

If you sell physical products, this is one of the highest-leverage decisions in your books and one of the least understood. This guide walks all three main methods through a single worked example, covers what the IRS and IFRS actually permit, and helps you pick the one that fits your business.

Why the Same Item Has More Than One Cost

Inventory is bought in batches, at prices that drift. Suppliers raise prices, freight fluctuates, you catch a volume discount one month and pay a rush premium the next. By the time a customer buys a unit off your shelf, you are typically holding units acquired at several different costs — and those units are physically indistinguishable.

So when one sells, your books have to answer a question the warehouse cannot: which unit left? Since nobody is going to trace the serial number of a box of screws, accounting standards let you adopt a consistent assumption instead. That assumption is your inventory costing method, and it is a flow-of-cost assumption, not a claim about the flow of goods. You can run your warehouse strictly oldest-stock-first and still use LIFO on your books.

This matters because cost of goods sold is usually the largest expense on a product business's income statement. Change the method and you change COGS; change COGS and you change gross profit, net income, and taxes owed. Here is exactly how much.

The Three Inventory Costing Methods, Worked Through One Example

Take a small retailer with three purchases in a year and no opening stock:

During the year they sell 150 units at $25 each, for revenue of $3,750. That leaves 150 units on the shelf at year end. Same shelf, same units, three methods.

FIFO: first in, first out

FIFO assumes the oldest units sell first. The 150 sold units come out of the March batch (100 at $10) and then the July batch (50 at $12), giving COGS of $1,600. What remains is the newest stock: 50 units at $12 and 100 at $15, so ending inventory is $2,100.

LIFO: last in, first out

LIFO assumes the newest units sell first. The 150 sold units come out of October (100 at $15) and then July (50 at $12), giving COGS of $2,100. What remains is the oldest stock: 100 units at $10 and 50 at $12, so ending inventory is $1,600.

Weighted average cost

Weighted average blends everything: $3,700 of cost across 300 units is $12.33 per unit. Sell 150 and COGS is $1,850; the 150 units remaining are also valued at $1,850. No layers to track, one number to carry.

A $500 swing in reported profit — roughly 30% — from an accounting choice alone. Notice also that in every column, COGS plus ending inventory equals the same $3,700. The methods do not create or destroy cost; they only decide how much of it you expense now versus how much you carry on the balance sheet into next year.

An inventory costing method doesn't change what you paid. It changes when you're allowed to say you paid it.

One more thing the table quietly shows: FIFO leaves the newest costs sitting in inventory, so your balance sheet stays close to current replacement value. LIFO leaves the oldest costs there — which over many years can leave a balance sheet showing stock at prices from a decade ago.

Which Inventory Costing Method Is Best for a Small Business?

For most small businesses, FIFO is the right default — and not because it flatters your profit. It mirrors how physical goods genuinely move in almost every business that sells perishables, seasonal items, or anything with a model year. It keeps your inventory asset close to what the stock is actually worth today. It is accepted under both US GAAP and IFRS. And it requires no election, no special filing, and no explaining.

Weighted average earns its place where units are genuinely interchangeable and prices move constantly: fuel, grain, chemicals, fasteners, bulk components. Tracking a cost layer for every delivery of the same commodity is effort spent for no better answer. Average cost also smooths out price volatility, so a single expensive purchase doesn't distort one month's margin.

LIFO is a tax strategy, not an operational one. In an inflationary period it charges your highest costs to COGS, lowering taxable income now. That is real money, but it comes with real strings — covered next — and it makes your gross margin look worse to a lender or a buyer at exactly the same time it lowers your tax. It is worth a conversation with your accountant, not a dropdown you flip on a Tuesday.

Specific identification is the fourth method and the only one that answers the "which unit sold?" question literally. If you sell twelve used cars a year, use it — the effort is trivial and the answer is exact. If you sell twelve thousand identical bolts, it is unworkable, which is why the other three exist.

The Rules You Can't Ignore

Inventory costing is one of the more heavily governed corners of small business accounting. Four constraints matter:

• Consistency is required. Both GAAP and the tax code expect you to apply the same method period after period. Switching methods to chase a favourable result in a given year is precisely what the consistency principle exists to prevent.
• LIFO requires an election. In the US you adopt LIFO by filing Form 970 with your return, and the LIFO conformity rule then binds you: if you use LIFO for tax, you must also use it in the financial statements you give lenders and investors. You cannot show a bank the FIFO profit and the IRS the LIFO one.
• IFRS prohibits LIFO outright. IAS 2 permits FIFO, weighted average, and specific identification only. If you report under IFRS — or expect to, because of an international parent, investor, or lender — LIFO is off the table entirely.
• Inventory can be written down, never up. Under GAAP, inventory carried at FIFO or average cost is measured at the lower of cost and net realisable value. If stock becomes obsolete or its market value falls below what you paid, you write it down. It never gets written back up because the market recovered.

Changing methods later generally requires IRS consent, usually via Form 3115, and it forces a restatement of comparative figures in your financial statements. The practical implication: choose deliberately at the start, because this is a decision that is far cheaper to make once than to unwind. Our GAAP for small business guide covers when these standards start binding a company your size.

The Part Nobody Warns You About: Recordkeeping

FIFO and LIFO are simple to describe and tedious to maintain, because both require you to track inventory in cost layers — a running record of every purchase batch, its unit cost, and how many units of it remain. Sell 150 units and something has to walk that stack, consuming the right layers in the right order, and post the resulting cost.

In a spreadsheet, this collapses quickly. Twelve deliveries a year across forty products is 480 layers to maintain by hand, and one mistake propagates silently through every subsequent sale — your COGS is wrong, your gross margin is wrong, and your inventory asset is wrong on the income statement and balance sheet at once. This is the real reason small businesses drift into "whatever the last purchase cost" rather than a genuine method: not a decision, just entropy.

How BizBooks Pro Handles Inventory Costing

BizBooks Pro supports FIFO, LIFO, and average cost, set once in Inventory Settings and applied automatically from then on. It maintains true cost layers behind the scenes, so every sale consumes the correct purchase batch in the correct order and the cost of goods sold entry is calculated for you rather than estimated.

The surrounding plumbing is set up in the same place: you map your inventory asset account, your COGS account, and separate accounts for inventory adjustments and shrinkage, so a write-down or a stock count variance lands somewhere deliberate instead of being buried in a catch-all expense. Because your costing method carries tax consequences, changing it triggers an explicit warning rather than saving silently — and if your company is set to report under IFRS, LIFO is disabled automatically, because IAS 2 does not permit it. That is the same per-company GAAP/IFRS setting that governs your report titles and presentation order.

Every costing entry is real double-entry bookkeeping posted to your general ledger, running on your own computer with your data in a local database — not a spreadsheet you maintain by hand and not someone else's cloud.

The Bottom Line

Inventory costing methods decide which of your purchase costs gets expensed when you make a sale — and in our example, that single choice moved gross profit by $500 on $3,750 of revenue without a single unit changing hands. FIFO is the sensible default for most small businesses: it tracks how goods really move, keeps the balance sheet current, and works under both GAAP and IFRS. Use weighted average when your units are interchangeable and prices swing. Treat LIFO as a deliberate US tax strategy with an election, a conformity rule, and an accountant attached. Then pick once, apply it consistently, and let your accounting software carry the layers so the number is right every time rather than most of the time.

Frequently Asked Questions

What are the inventory costing methods?

The four inventory costing methods permitted under US GAAP are FIFO (first in, first out), LIFO (last in, first out), weighted average cost, and specific identification. FIFO assumes your oldest units sell first, LIFO assumes your newest units sell first, weighted average blends every purchase into one running cost per unit, and specific identification tracks the actual cost of each individual item.

Which inventory costing method is best for a small business?

FIFO is the right default for most small businesses. It matches how physical goods usually move, it produces an ending inventory value close to current replacement cost, and it's accepted under both US GAAP and IFRS with no election to file. Weighted average is the better fit when units are interchangeable and prices bounce around — fuel, grain, bulk components. LIFO is a specialised tax strategy that's worth a conversation with your accountant before you adopt it.

How does FIFO vs LIFO change my profit?

When costs are rising, FIFO charges your oldest and cheapest units to cost of goods sold, which reports higher profit and leaves a higher inventory value on the balance sheet. LIFO charges your newest and most expensive units first, which reports lower profit and lower ending inventory. Weighted average lands between the two. The physical goods on your shelf are identical in all three cases — only the accounting differs.

Is LIFO allowed under IFRS?

No. IAS 2 prohibits LIFO, so any company reporting under IFRS must use FIFO, weighted average, or specific identification. LIFO remains legal in the United States under US GAAP and the tax code, which is why it's largely a US-only method and why businesses that report internationally avoid it.

Can I change my inventory costing method later?

Not casually. Accounting standards require you to apply a costing method consistently from period to period, and in the United States a change generally requires IRS consent, usually filed on Form 3115. Adopting LIFO in the first place requires an election on Form 970, and the LIFO conformity rule means that if you use LIFO for tax you must also use it in your financial statements. Talk to your accountant before changing anything.

Does BizBooks Pro support FIFO, LIFO, and average cost?

Yes. BizBooks Pro supports FIFO, LIFO, and average cost, set once in Inventory Settings and applied automatically every time you sell. It tracks inventory in cost layers so FIFO and LIFO consume the correct purchase batch, posts the resulting cost of goods sold entry to the accounts you designate, warns you before any costing method change because of the tax consequences, and disables LIFO automatically for companies that report under IFRS.

Related Articles

• How to Read a Profit and Loss Statement: A Small Business Guide
• GAAP for Small Business: What It Is, Who Actually Needs It, and Why It Matters
• How to Calculate Depreciation for Small Business (4 Methods, With Examples)
• How to Categorize Business Expenses: A Small Business Guide
• How to Read a Balance Sheet: A Small Business Owner's Guide
• How to Set Up a Chart of Accounts for Small Business
• The Month-End Close Checklist for Small Business (8 Steps, In Order)
• What Is a General Ledger? A Plain-English Guide for Small Business