FIFO vs. LIFO: A Comparative Analysis of Inventory Valuation Methods

How does your choice between FIFO vs. LIFO impact your business’s financial health? Inventory valuation is more than just an accounting requirement—it directly influences your cost of goods sold (COGS), tax liabilities and profit margins. Choosing the right valuation method can shape key business decisions and financial outcomes, guiding smarter purchasing and inventory management strategies.

With FIFO—first in, first out—the oldest inventory is sold first, making it ideal for businesses where goods need to be rotated regularly, such as in food or retail. LIFO—last in, first out—assumes the most recent purchases are sold first, which can affect profit margins during inflationary times. Choosing between the two is more complex than you might think.

In this blog, we’ll explore both methods, comparing their advantages, drawbacks, and the best scenarios for each:

• What is FIFO?
• What is LIFO?
• LIFO and FIFO: impact of inflation
• FIFO vs. LIFO: financial reporting
• LIFO and FIFO: taxes
• Example of LIFO vs. FIFO
• How to calculate FIFO and LIFO
• Which method is better: FIFO vs. LIFO

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What is FIFO?

First in, first out (FIFO) assumes that the oldest inventory is sold or used first. The earliest purchased items are recorded as the cost of goods sold (COGS). This method aligns well with the natural flow of goods, particularly in industries where products have a shelf life, such as food and beverages, pharmaceuticals and retail. FIFO helps ensure that perishable or time-sensitive items are sold before they spoil or become obsolete.

FIFO is legal and widely accepted in most countries, including those following International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP).

Many businesses prefer FIFO as it often reflects a more accurate representation of inventory costs during periods of inflation, showing higher profits when prices rise since older, cheaper stock is sold first.

How does FIFO work?

Let’s say a company sells canned goods. 

They purchase 100 cans in January at $2 each, then buy 100 more in February at $3 each.

Under the FIFO method, if the company sells 150 cans in March, the first 100 cans sold would be valued at $2 each (from the January purchase), and the next 50 cans would be valued at $3 each (from the February purchase). 

This leaves 50 cans from the February batch still in stock, valued at $3 each.

In this scenario, FIFO reflects the actual flow of inventory—older stock is sold first, and newer stock remains on hand. 

Advantages of FIFO

• Reflects natural inventory flow: FIFO aligns with the actual flow of goods for most businesses, ensuring older inventory is sold first. This is particularly useful for industries dealing with perishable items, as it prevents spoilage and waste
• Results in higher profits in times of inflation: FIFO uses older, less expensive inventory to calculate the cost of goods sold (COGS). This results in lower COGS and higher reported profits, reflecting the cost structure more favorably
• Easier to implement and understand: FIFO is straightforward and intuitive since it follows the logical sequence of selling the oldest stock first. This simplicity makes it easier for businesses to manage and for staff to understand, reducing errors and complexity in inventory tracking

Disadvantages of FIFO

• Higher taxes in inflationary periods: FIFO can lead to higher taxable income and, consequently, increased tax liabilities for the business
• Not always reflective of current costs: as older inventory is sold first, the remaining stock may be priced much higher, creating a gap between the cost of goods sold and current market prices. This can make financial reporting less aligned with the true costs a business faces when restocking inventory

What is LIFO?

The LIFO (last in, first out) retail inventory method assumes that the most recently acquired inventory is sold or used first, meaning the newest stock is recorded as the cost of goods sold. 

LIFO is particularly useful in industries where costs are rising because it matches the latest, often higher, costs with current revenue, which can help reduce taxable income during inflationary periods.

However, LIFO is not widely accepted internationally. It is prohibited under the International Financial Reporting Standards (IFRS) but is legal and commonly used in the United States, where it is permitted under the Generally Accepted Accounting Principles (GAAP). 

Businesses in industries like retail or manufacturing, where prices are subject to frequent fluctuations, may adopt LIFO to minimize ta  x liabilities when costs are rising.

How does LIFO work?

A company purchases 100 units of a product in January at $5 each and another 100 units in February at $7 each. 

In March, they sold 150 units. Under the LIFO method, the 100 units sold in March would be valued at $7 each (from the February purchase), and the remaining 50 units would be valued at $5 each (from the January purchase). 

After this sale, the company would have 50 units from the January purchase still in stock, valued at $5 each.

By selling the most recent (and more expensive) inventory first, LIFO increases the cost of goods sold during inflationary times, reducing taxable income. However, it leaves older, potentially cheaper inventory on the books. 

Advantages of LIFO

• Lower taxes in times of inflation: since LIFO uses the most recent, often higher-cost inventory to calculate the cost of goods sold (COGS), it results in lower reported profits during inflationary periods. This leads to reduced taxable income and lower tax liabilities
• Better matching of current costs with current revenues: LIFO allows businesses to match their most recent inventory costs with their current sales revenue. This can provide a more accurate reflection of the true cost of doing business in periods of rising prices, offering a clearer picture of profitability based on current market conditions

Disadvantages of LIFO 

• Lower profits: by using the most recent, higher-cost inventory to calculate the cost of goods sold (COGS), LIFO results in lower profits during inflationary periods. This can negatively impact financial statements and reduce investor appeal
• Potential for manipulation: LIFO can be manipulated by adjusting the timing of inventory purchases, allowing businesses to influence profits and tax liabilities. This creates opportunities for intentional distortions in financial reporting
• Niche acceptance: LIFO is not accepted under International Financial Reporting Standards (IFRS), making it illegal in many countries. It is only permitted in the United States under Generally Accepted Accounting Principles (GAAP), limiting its use in global business environments

LIFO and FIFO: impact of inflation

FIFO and LIFO affect your COGS in different ways, which in turn impacts how you record gross profit, net income and tax liability.

Under FIFO, the oldest, often cheaper, inventory is used first to calculate COGS. In times of inflation, this results in lower COGS, leading to higher gross profit and net income. On the balance sheet, inventory valuation reflects the cost of more recent purchases, meaning the value of the remaining inventory is higher, especially during inflationary periods. This gives a more accurate reflection of current market prices.

In contrast, LIFO uses the most recent, typically higher-cost inventory to calculate COGS. During inflation, this increases COGS, which lowers gross profit and net income, ultimately reducing the company’s tax liability. The remaining inventory on the balance sheet is valued at older, lower costs, which can understate the true value of current inventory in times of rising prices.

FIFO vs. LIFO: financial reporting

Once a business selects FIFO or LIFO, it is essential to consistently apply it across reporting periods. Inconsistent use of different methods can distort financial statements, making it difficult to track performance over time and potentially misleading investors or stakeholders.

If a company uses LIFO for tax reporting but wants to show a FIFO comparison for financial reporting, it should calculate the LIFO reserve (the difference between FIFO and LIFO inventory values) and disclose it in the notes section of the financial statements.

Regulatory agencies, like the IRS in the United States, require businesses to adhere to the same inventory method unless formally requesting a change. Such a change must be justified and approved to prevent companies from switching methods to manipulate earnings, tax liabilities or financial outcomes. 

Inconsistent application can lead to non-compliance with Generally Accepted Accounting Principles (GAAP), resulting in audits, penalties or reputational damage. 

LIFO and FIFO: taxes

FIFO and LIFO significantly impact tax obligations, particularly during periods of inflation. 

Businesses in the US often choose LIFO because of the LIFO Conformity Rule, which requires that if a company uses LIFO for tax purposes, they must also use it for financial reporting. This allows businesses to show lower profits and pay less in taxes, especially in inflationary periods. 

However, using LIFO can create challenges, as it’s not permitted under International Financial Reporting Standards (IFRS), limiting its use internationally. 

FIFO impacts on taxes

1. Higher tax liabilities in inflation: FIFO leads to higher taxable income and, therefore, higher taxes
2. Accurate inventory valuation: FIFO reflects more accurate inventory valuation on the balance sheet, which can help reduce discrepancies in tax reporting
3. Increased profits impact: businesses using FIFO may face consistently higher tax obligations due to increased net income from lower COGS

LIFO impacts on taxes

1. Lower tax liabilities in inflation: LIFO lowers reported profits and tax liabilities, making it a popular choice for tax minimization
2. LIFO reserve disclosure: companies using LIFO for tax purposes may need to disclose a LIFO reserve in their financial statements. This shows the difference between LIFO and FIFO valuations and is required for accurate tax reporting under GAAP

Example of LIFO vs. FIFO

Let’s go over how LIFO and FIFO would change financial recording for the same inventory. 

Initial purchase:  

• 100 units purchased in January at $10 each = $1,000
• 100 units purchased in February at $12 each = $1,200
• 100 units purchased in March at $14 each = $1,400

Total inventory: 300 units

Sales:  

• 200 units sold in April

Under FIFO

COGS:  

• 100 units from January = 100 × $10 = $1,000  
• 100 units from February = 100 × $12 = $1,200  

Total COGS = $2,200

Ending inventory: 100 units from March = 100 × $14 = $1,400

Under LIFO

COGS:  

• 100 units from March = 100 × $14 = $1,400  
• 100 units from February = 100 × $12 = $1,200  

Total COGS = $2,600

Ending inventory: 100 units from January = 100 × $10 = $1,000

How to calculate FIFO and LIFO

The formulas for calculating FIFO and LIFO focus on determining the COGS and ending inventory, depending on the sequence of inventory usage or sale.

FIFO formula

COGS = Quantity sold X Cost of oldest inventory

Ending inventory formula for FIFO

Remaining units X Cost of most recent inventory

LIFO formula

COGS = Quantity sold X Cost of newest inventory

Ending inventory formula for LIFO

Remaining units X Cost of oldest inventory

What is the main difference between FIFO and LIFO inventory valuation? 

Which method is better: FIFO or LIFO? 

Choosing between FIFO and LIFO depends on a company’s financial strategy, industry, goals and places of business.

FIFO is often better for businesses wanting higher profits and accurate reflection of current inventory value, particularly in industries where stock naturally flows out in the order it was received, like retail or food. It is the only mainstream choice for businesses operating outside of the US.

LIFO, on the other hand, is advantageous during periods of inflation for reducing tax liabilities by using higher-cost inventory for calculating the cost of goods sold (COGS), though it may result in lower profits on financial statements. It is a viable choice for businesses operating only in the US.

Companies should align their choice with their long-term financial goals. Businesses prioritizing tax reduction might prefer LIFO, while those focused on profitability and international compliance should consider FIFO.

Bottom line

FIFO ensures higher profits and reflects accurate inventory value, while LIFO reduces tax liabilities in inflationary periods. If you’re operating in the US, you can choose between FIFO vs. LIFO, while international companies must use LIFO. 

Now is the time to evaluate your current inventory management practices. Are they aligned with your company’s strategy? Implementing the right inventory techniques can significantly boost efficiency and ensure accurate reporting.

For businesses looking to optimize further, consider exploring Lightspeed’s inventory management software. With real-time tracking, automated reorder recommendations and seamless integration with top ERP systems, Lightspeed enhances both efficiency and accuracy, making it a powerful tool for better inventory control. Why not see for yourself? 

Frequently asked questions about FIFO and LIFO

How do FIFO and LIFO impact financial statements?

FIFO results in higher profits during inflation because it uses older, cheaper inventory for Cost of Goods Sold (COGS), increasing net income. LIFO, by using more recent, higher-cost inventory, results in lower profits, reducing taxable income. Both methods affect profitability and inventory value on the balance sheet.

Are FIFO and LIFO methods compliant with GAAP and IFRS?

FIFO is compliant with both GAAP and IFRS, making it widely accepted internationally. 

LIFO, however, is only allowed under GAAP and is prohibited by IFRS, meaning businesses using LIFO cannot comply with international financial reporting standards.

Can companies switch between FIFO and LIFO?

Yes, companies can switch between FIFO and LIFO, but they must get approval from the IRS in the US (see form 970) and follow strict reporting guidelines. Frequent switching may lead to scrutiny from regulatory authorities and complicate financial reporting.

How do FIFO and LIFO affect inventory turnover?

FIFO usually results in a higher inventory turnover rate because older, often lower-cost inventory is sold first, speeding up stock movement. LIFO, by selling more recent inventory first, may result in a slower turnover rate, especially in industries with rising costs or inflation.