Lesson 67 - Beginner accounting course

67. FIFO vs. LIFO vs. Weighted Average Cost

Inventory valuation plays a crucial role in financial reporting and tax calculations. The three most common inventory accounting methods are FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and Weighted Average Cost (WAC). Each method impacts cost of goods sold (COGS), taxable income, and financial statements differently.

1. Understanding the Three Inventory Valuation Methods 

2. Example: Comparing FIFO, LIFO, and WAC

Imagine a company purchases 100 units of inventory at different prices:

The company then sells 50 units. Let’s calculate the cost of goods sold (COGS) under each method:

FIFO Calculation (First-In, First-Out)

• 30 units from Jan 1 purchase at $10 each → $300

• 20 units from Feb 1 purchase at $12 each → $240

• COGS = $540

• Ending Inventory = $660 (remaining 50 units: 20 at $12, 30 at $14)

LIFO Calculation (Last-In, First-Out)

• 30 units from Mar 1 purchase at $14 each → $420

• 20 units from Feb 1 purchase at $12 each → $240

• COGS = $660

• Ending Inventory = $540 (remaining 50 units: 20 at $12, 30 at $10)

WAC Calculation (Weighted Average Cost)

• Average cost per unit = $1,200 ÷ 100 = $12/unit

• 50 units sold at $12/unit → $600

• COGS = $600

• Ending Inventory = $600 (50 units × $12/unit)

3. Impact on Business Performance

A. Effect on Profits and Taxes

• FIFO results in higher profits when prices rise, but higher taxes.

• LIFO results in lower profits, reducing taxable income during inflation.

• WAC stabilizes costs, giving a balanced approach.

B. Effect on Financial Statements

• FIFO shows a higher inventory value on the balance sheet.

• LIFO shows a lower inventory value, reducing net assets.

• WAC provides consistent cost flow, useful for businesses with fluctuating prices.

4. Choosing the Right Inventory Method 

Key Takeaways

• FIFO is best for businesses wanting higher profits and accurate inventory valuation.

• LIFO is ideal for reducing tax liability but not allowed under IFRS.

• WAC is useful for companies needing stable costs and simpler bookkeeping.

Choosing the right inventory method depends on business strategy, tax planning, and financial reporting goals.