FIFO vs. LIFO: Impact on Margin, Taxes, and Cash

FIFO vs. LIFO is a choice about which costs the accounting system assumes leave inventory first when goods are sold, and that single assumption changes reported margin, taxable income, the balance sheet and sometimes the cash a company pays to the tax authority. This guide is part of demand planning and inventory optimization, leads to inventory valuation methods compared and how to build an inventory budget, and connects to cash flow management. It does not change what physically happens in the warehouse. A company can ship its oldest stock first and still use LIFO for its books, or ship newest first and use FIFO. What changes is the cost attached to the goods sold and the cost attached to the goods remaining. This guide explains both methods, works one example through FIFO, LIFO and weighted average with checked arithmetic, shows how the results reverse when prices fall, explains the LIFO reserve and LIFO liquidation, and sets out what planners and finance leaders should consider. It is general information, not accounting or tax advice, and the rules differ by country and over time, so confirm the current position with your accountants.

What each method assumes

First in, first out (FIFO) assumes the oldest costs are the first to be charged to cost of goods sold. Whatever remains in inventory is therefore valued at the most recent purchase costs. When purchase prices rise over time, FIFO charges older, lower costs against current revenue, which produces a higher gross margin, and it leaves the balance sheet inventory close to current replacement cost.

Last in, first out (LIFO) assumes the newest costs are charged to cost of goods sold first. The remaining inventory is valued at the oldest costs, sometimes costs from many years ago. When prices rise, LIFO charges current, higher costs against current revenue, which produces a lower gross margin and a lower taxable profit, and it leaves the balance sheet inventory below current replacement cost.

Weighted average cost blends all the costs available into a single average and uses it for both the goods sold and the goods remaining. It sits between the two in a period of changing prices.

Which methods are allowed depends on the accounting framework. In broad terms, US generally accepted accounting principles permit FIFO, LIFO and average cost, while international financial reporting standards do not permit LIFO. In the United States, a company that uses LIFO for tax purposes is generally required to use it for its financial reporting too, which is often called the conformity requirement. These rules can change and have exceptions, so treat this paragraph as orientation and not as advice.

One example, three methods

A company starts a period with 100 units at a cost of $10 each. It then buys 100 units at $12 and later 100 units at $14. It sells 150 units at $25 each (illustrative, and ignoring operating expenses). The total cost of goods available for sale is 100 × 10 + 100 × 12 + 100 × 14 = 1,000 + 1,200 + 1,400 = $3,600 across 300 units. Revenue is 150 × 25 = $3,750.

Under FIFO, the 150 units sold come from the oldest layers: all 100 units at $10 and 50 of the units at $12. Cost of goods sold is 1,000 + 600 = $1,600. Ending inventory is the remaining 50 units at $12 and the 100 units at $14, which is 600 + 1,400 = $2,000. Gross profit is 3,750 - 1,600 = $2,150, a margin of 57.3 percent.

Under LIFO, the 150 units sold come from the newest layers: all 100 units at $14 and 50 of the units at $12. Cost of goods sold is 1,400 + 600 = $2,000. Ending inventory is the 100 units at $10 and 50 at $12, which is 1,000 + 600 = $1,600. Gross profit is 3,750 - 2,000 = $1,750, a margin of 46.7 percent.

Under weighted average, the average cost is 3,600 / 300 = $12. Cost of goods sold is 150 × 12 = $1,800 and ending inventory is also 150 × 12 = $1,800. Gross profit is 3,750 - 1,800 = $1,950, a margin of 52.0 percent.

Check each method: cost of goods sold plus ending inventory must equal the $3,600 available. FIFO: 1,600 + 2,000 = 3,600. LIFO: 2,000 + 1,600 = 3,600. Weighted average: 1,800 + 1,800 = 3,600. The same goods and the same sales produce a gross profit that ranges from $1,750 to $2,150, which is a difference of $400, or 10.7 percent of revenue (400 / 3,750 = 0.1067). The gap is purely a matter of accounting convention in a period when purchase costs rose.

What it means for tax and cash

If the tax rate is 25 percent and, for simplicity, gross profit is taxable profit, tax under FIFO is 0.25 × 2,150 = $537.50 and tax under LIFO is 0.25 × 1,750 = $437.50. The difference is $100, which is 0.25 × 400. In a period of rising costs, LIFO defers $100 of tax in this small example. That is real cash that stays in the business, though it is a deferral and not a permanent saving unless inventory layers are never liquidated. This is the main reason companies in the United States have historically used LIFO when input costs rise persistently. A company with a large inventory and steady inflation in its costs can defer a material sum of tax each year.

The cash effect sits entirely in the tax line. The company buys the same goods and sells them at the same price whichever method it uses, so operating cash flow before tax is identical. For a planner, that is a useful point: the method does not make the stock turn faster or slower. It changes the story the accounts tell about it.

When prices fall

Reverse the example. Suppose the layers are 100 units at $14, then 100 at $12, then 100 at $10, and the company sells the same 150 units at $25. FIFO now charges the old, high costs first: cost of goods sold is 100 × 14 + 50 × 12 = 1,400 + 600 = $2,000, and gross profit is 3,750 - 2,000 = $1,750. LIFO charges the newest, low costs first: cost of goods sold is 100 × 10 + 50 × 12 = 1,000 + 600 = $1,600, and gross profit is $2,150. The method that looks conservative in an inflationary period looks aggressive when prices fall. For businesses whose costs move up and down, such as those buying commodity inputs, the effect on reported margin can swing from year to year, which is a good reason to explain the method clearly in management reporting.

The LIFO reserve

Companies that use LIFO for reporting usually track the difference between what inventory would be worth under FIFO and what it is carried at under LIFO. This difference is the LIFO reserve. In the first example, FIFO inventory is $2,000 and LIFO inventory is $1,600, so the LIFO reserve is $400. Analysts add the reserve back to inventory, and the change in the reserve back to cost of goods sold, to compare a LIFO company with a FIFO company. The same adjustment matters for internal ratios. Inventory turnover and days of inventory calculated on LIFO values will look different from those calculated on FIFO values, with LIFO turnover typically higher in rising-cost periods because the inventory is carried at old, low costs. When benchmarking, compare like with like. See inventory turnover ratio formula, with examples.

LIFO liquidation

LIFO has a hidden risk. Because inventory is carried at old costs, reducing inventory below its usual level exposes those old layers to cost of goods sold. Suppose a company's LIFO layers include 1,000 units at an old cost of $10 and current replacement cost is $14. If a stock reduction forces the company to sell 400 units from the old layer, cost of goods sold falls by 400 × (14 - 10) = $1,600 compared with what it would be if the units had been replaced at current cost. Profit rises by $1,600 and so does the tax bill. This is a LIFO liquidation gain. It is not a sign of operational improvement, and it can be an unwelcome tax event. It also creates a tension with good inventory management: a program to cut inventory and release cash can trigger a tax charge in a LIFO company. Plan reductions with finance, and quantify the effect before the reduction, not after.

Practical considerations for planners

Planners rarely choose the cost method, but they feel its effects. Margin by product can look different under each method, and a product that appears profitable under FIFO in a rising period may look less so under LIFO. Standard cost systems, discussed in the next guide, often sit on top of the method and produce variances that are reported separately. When the finance team asks for inventory reductions, ask whether the company uses LIFO and what the liquidation effect would be. When comparing margins across periods, check whether purchase prices have moved, because a margin change may come from the cost method and not from pricing or mix. When forecasting, use the cost basis that finance uses in the plan. See financial reconciliation in S&OP.

Choosing between the methods

The decision belongs to finance leadership with advice from accountants and tax advisers. The factors usually discussed include the rules in the company's jurisdiction, the pattern of input costs, the importance of tax deferral, the desire for balance sheet inventory to reflect current costs, the administrative burden, the consistency with lenders' expectations and the plans for the business. A switch of method is a significant change that generally needs justification and, in some cases, approval from the tax authority. A company that expects to shrink inventory, or that sells in a deflationary market, may gain little from LIFO. A company with a large, stable inventory and steady cost inflation may gain more. Weighted average is often preferred for its simplicity when goods are interchangeable and there are many small receipts.

Common mistakes

Comparing margins across companies without checking the cost method is the most common error. A second is assuming the cost method reflects the physical movement of goods. A third is overlooking LIFO liquidation when planning an inventory reduction. A fourth is mixing methods across entities or product lines without understanding how consolidation treats them. A fifth is changing a method to improve reported profit without considering the tax and reporting consequences. A sixth is ignoring the effect of the method on inventory turnover and benchmark comparisons.

FAQs

What is the main difference between FIFO and LIFO?

FIFO charges the oldest costs to cost of goods sold first and values remaining stock at recent costs. LIFO charges the newest costs first and values remaining stock at older costs.

Which method gives a higher profit when prices rise?

FIFO gives a higher reported profit when prices rise, because older, lower costs are matched against current sales.

Is LIFO allowed everywhere?

No. International financial reporting standards do not permit LIFO, while US rules do. Confirm the rules that apply to your company with your accountants.

What is the LIFO reserve?

The difference between inventory valued under FIFO and inventory valued under LIFO. It is used to compare companies and adjust ratios.

Does the cost method change how fast inventory turns?

No. It changes the recorded cost of goods sold and inventory, and therefore ratios such as turnover, but not the physical flow of goods or the operating cash flow before tax.