FIFO, LIFO & Weighted Average — Compute cost of goods sold and ending inventory under FIFO, LIFO, and weighted average

Before formal accounting standards existed, merchants tracked goods using simple physical counts—what was on the shelf was what you owned, and what left the store was what you sold. As commerce scaled during the Industrial Revolution and firms began holding large, heterogeneous inventories purchased at varying prices, a pressing question emerged: when identical items are bought at different costs, which cost should be assigned to the units sold and which to the units remaining? The answer to that question directly affects a company's reported gross profit, income tax liability, and balance sheet valuation of assets, making the choice of inventory cost-flow assumption one of the most consequential decisions in financial reporting.

The core problem remains deceptively simple: when a retailer buys 100 units of the same product in January at $10 each and another 100 units in March at $12 each, then sells 120 units in April, which costs—$10, $12, or some blend—should attach to the 120 units sold and which to the 80 units still on hand? The three dominant approaches—FIFO, LIFO, and Weighted Average—each answer that question differently, producing different figures for cost of goods sold, ending inventory, gross profit, and net income from identical physical transactions.

At the foundation of every inventory system lies the cost-flow assumption—a convention that determines the sequence in which previously recorded costs are transferred from the Inventory account on the balance sheet to Cost of Goods Sold on the income statement. Crucially, the cost-flow assumption does not need to mirror the physical flow of goods; a grocery store may physically sell older milk first, yet an electronics retailer selling identical USB cables may use any permissible assumption regardless of which physical unit ships. The choice affects two interrelated magnitudes: the cost of goods sold (COGS) that reduces revenue on the income statement and the ending inventory (EI) that remains as a current asset on the balance sheet.

Observe the pattern in the diagram above. Under FIFO, the oldest (cheapest) layers flow to COGS first, producing the lowest COGS ($1,240) and the highest ending inventory ($1,660) when prices are rising. Under LIFO, the newest (most expensive) layers flow out first, yielding the highest COGS ($1,540) and the lowest ending inventory ($1,360). The weighted average method falls between the two extremes by blending all costs into a single per-unit figure of $11.60. These relationships hold whenever prices trend upward; in a deflationary environment, the rankings reverse.

Regardless of the cost-flow assumption chosen, the fundamental accounting identity governing inventory remains the same. The total cost of goods available for sale must equal the sum of cost of goods sold and ending inventory. The three methods differ only in how they split that total between the income statement and the balance sheet.

To consolidate the differences, consider a single set of inventory data and compute COGS and ending inventory under all three methods. Suppose a company has no beginning inventory and the following purchases during the period: Jan 5: 200 units at $8, Mar 15: 300 units at $10, Sep 20: 100 units at $13. The company sells 400 units during the period. Total goods available for sale equal 600 units costing $5,900.

The chart makes visually apparent what the table shows numerically: the three methods simply redistribute the same total pool of cost. When prices trend upward, FIFO assigns lower (older) costs to COGS—boosting reported gross profit—while LIFO assigns higher (newer) costs to COGS—lowering reported profit but also lowering the current tax obligation. The weighted average method smooths both extremes. In a period of declining prices, these rankings reverse entirely: FIFO would produce the highest COGS and LIFO the lowest.

Greenfield Electronics has no beginning inventory on January 1 and records the following transactions during the quarter:

No single cost-flow assumption is universally superior; each has trade-offs that affect different stakeholders—managers, investors, creditors, and tax authorities—in different ways. A company's choice often reflects a strategic balance between tax savings, financial statement presentation, and regulatory constraints.

The three periodic cost-flow assumptions form the foundation for several advanced inventory topics encountered in intermediate and advanced accounting courses. Understanding these baseline methods is essential before tackling the complexities of perpetual systems, dollar-value LIFO, and inventory estimation techniques.

As you progress in your accounting coursework, you will also encounter the LIFO conformity rule in greater detail: under IRC §472, any firm that uses LIFO for tax purposes must also use LIFO in its primary financial statements sent to shareholders and creditors—though supplemental FIFO disclosures are permitted. This rule has no parallel under IFRS, which simply prohibits LIFO outright. The ongoing debate about potential U.S. LIFO repeal, driven partly by IFRS convergence efforts, illustrates how deeply intertwined inventory methods are with tax policy, financial reporting, and international harmonization.