- Nov 29, 2022
- 3 min read

FIFO vs. LIFO vs. Average Costing Inventory Management and Cost of Goods Sold

Updated: Feb 6

FIFO vs. LIFO vs. Average Costing Inventory Management and Cost of Goods Sold

1.) FIFO (First-In, First-Out):

Under FIFO, the cost of goods sold (COGS) is calculated based on the assumption that the first inventory items purchased or produced are the first ones to be sold or used.
In other words, under FIFO, the oldest inventory costs are matched with revenue first, resulting in a lower COGS and higher reported profits during periods of rising prices.
FIFO is often perceived as providing a more accurate representation of a company's inventory valuation, as it reflects the actual flow of goods in many industries where products have a short shelf life or where new inventory is regularly added.

2.) LIFO (Last-In, First-Out):

Under LIFO, the cost of goods sold (COGS) is calculated based on the assumption that the most recently acquired or produced inventory items are the first ones to be sold or used.
In other words, under LIFO, the newest inventory costs are matched with revenue first, resulting in a higher COGS and lower reported profits during periods of rising prices.
LIFO is often favored by companies in industries with inflationary trends, as it can help minimize taxable income by reducing reported profits and deferring taxes.

3.) Average Costing:

Under average costing, the cost of goods sold and the value of ending inventory are calculated based on the average cost of all units of inventory available for sale during the accounting period.
To determine the average cost per unit, the total cost of goods available for sale is divided by the total number of units available for sale.
This method smoothes out fluctuations in inventory costs by blending the costs of older and newer inventory purchases or production runs.
Average costing is often used in industries where specific identification of inventory items is impractical or where there is a relatively homogeneous inventory mix.

Key differences: FIFO vs. LIFO vs Average Costing Inventory Management:

Impact on Profit: FIFO tends to result in higher reported profits during periods of rising prices, while LIFO tends to result in lower reported profits.
Tax Implications: LIFO may have tax advantages in inflationary environments by reducing taxable income, while FIFO may result in higher taxable income.
Balance Sheet Valuation: FIFO typically results in a higher inventory valuation on the balance sheet during periods of rising prices, while LIFO may result in a lower inventory valuation.
Cash Flow: LIFO can result in higher cash flows due to lower reported profits and taxes, while FIFO may result in lower cash flows in certain situations.

The choice between FIFO and LIFO depends on various factors, including industry norms, tax considerations, financial reporting requirements, and management preferences. Both methods have their advantages and disadvantages, and companies should carefully evaluate the implications of each method before selecting the most appropriate inventory costing method for their business. Average costing provides a middle ground between FIFO and LIFO, smoothing out fluctuations in inventory costs by calculating a weighted average cost for all units available for sale.

GAAP requires inventory to be valued at the lower of cost or market value. This means that if the market value of the inventory drops below its cost, the inventory should be written down to its market value to reflect the decline in value. This ensures that inventory is not overstated on the balance sheet. GAAP also requires consistency in inventory valuation methods. Once a method is chosen, it should be consistently applied from one accounting period to another to ensure comparability and reliability of financial information. Under specific identification method, each item in inventory is individually costed. This method is often used for high-value or unique items where tracking the cost of each item is feasible. GAAP allows for inventory write-offs under certain circumstances. Inventory write-offs are necessary when the value of inventory on hand is determined to be lower than its recorded cost on the balance sheet. The primary reason for inventory write-offs is the recognition of losses due to obsolescence, damage, theft, or decreases in market value. GAAP requires that inventory be valued at the lower of cost or market value, so if the market value of inventory falls below its recorded cost, a write-down or write-off may be necessary.

How do different accounting software packages calculate inventory?

QuickBooks Online utilizes FIFO inventory valuation

Oracle Netsuite utilizes Average Costing

Xero utilizes Average Costing

Sage utilizes Average Costing (flexibility per item/BIN)

SAP utilizes Average Costing

SOS Inventory Specific Identification (options: LIFO, FIFO and Average Costing)

Finale Inventory utilizes Average Costing

Dynamics 365 Average Costing