LIFO and FIFO are some of the most recognizable accounting terms in the industry, even if their meaning is unclear. FIFO, LIFO, and weighted average are concepts that apply to businesses who carry inventory, like manufacturers and retailers.
At the beginning of a period, you have lots of inventory that is ready to be sold to customers. You may also buy or create more inventory in that time. At the end of the period, customers have presumably scooped up some of that inventory and some of it remains. That’s when you’ll analyze your sales and your remaining inventory to calculate Cost of Goods Sold (COGS) and Ending Inventory.
COGS shows you how much the inventory that you sold to customers ended up costing you. Ending Inventory tells you how much the inventory that you currently have on hand is worth. Because the cost of materials can change and fluctuate, it’s important that you use the same inventory reporting method to calculate these.
For example, if you’re make tents, the cost of the fabric you purchase could go up or down over time. The tents that you made at the beginning of the month that are still in the warehouse could cost less to make than the ones that you are manufacturing at the end of the month. When a customer goes to your website and places an order, they see no difference between the two tents. But your accountant cares if you sold a tent that cost $30 to make vs. a tent that cost you $35 to make. This is where FIFO, LIFO, and weighted average come in. They provide some standard processes for managing inventory and tracking costs. This comes in handy when you start to analyze your inventory and need accurate data to help you.
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First-In, First-Out (FIFO)
Under FIFO rules, COGS is calculated using the cost of your inventory at the beginning of the period. In other words, if a customer places an order for your tent, the $30 tents are sold through first. They were made first, so they get shipped out first.
Your ending inventory, or what’s left at the end of the period, then is made up of $35 tents. This vastly oversimplifies the process, but it shows the importance of using a consistent process in order to get accurate numbers.
Last-In, First-Out (LIFO)
LIFO flips FIFO on its head and calculates COGS using the cost of inventory at the end of the period. Under this process, you would sell through your $35 tents first, even though they were made last. This would leave your older inventory (and the costs associated with making those items) in inventory longer.
In most cases, this way of managing inventory doesn’t make much sense. So it’s not as commonly used as FIFO or weighted average, which we’ll cover next.
The weighted average approach, as its name implies, takes an average of the costs throughout the period. If half of your inventory cost you $30 to make and the other half cost you $35, the weighted average approach would use $32.50 to calculate both the COGS and ending inventory calculations.
Many online inventory management systems use the weighted average approach. Some more sophisticated options allow for FIFO or LIFO.
Choosing the Right Inventory Management Approach
While there may be uses for each of these inventory management methods, the reality is that most businesses will use FIFO. It’s the easiest calculation and the most logical approach, so unless there is a strong reason for using LIFO or weighted average, FIFO is the default.
If you sell high volumes of small items, like nails and screws for example, and the costs change regularly, weighted average may make more sense. However, if you have a complicated inventory, using an inventory system that can match your selling practices and calculate all of this for you will be key. If you have a pretty simple inventory, FIFO will make the most sense.