FIFO, LIFO and weighted average when prices rise or fall

What does the cost of inventory include?

Inventory is recorded at the cost of getting the goods to where they are sold, in the condition they are sold. These product costs sit on the balance sheet until the goods are sold. Then they move to cost of sales. The costs are similar under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP).

Included: the purchase price less trade discounts and rebates (plus non-recoverable taxes and duties, and freight in), conversion costs such as direct labor and production overhead, and other costs of bringing the goods to their present location and condition. Expensed as incurred: abnormal waste, storage (unless needed in production), administrative overhead and selling costs.

A cost incurred on goodsdoes it bring the goods to their present location and condition?

• Capitalize in inventory Use it
  • Purchase cost less discounts, plus non-recoverable taxes and freight in
  • Conversion costs direct labor and production overhead
• Expense as incurred Use it
  • Abnormal waste
  • Storage unless a necessary production step
  • Administrative and selling costs

How do the cost formulas split the cost?

Every formula splits the same pool of cost between the income statement and the balance sheet. That pool is the cost of goods available for sale : beginning inventory plus purchases. What is not sold stays as ending inventory , and what is sold becomes cost of sales (cost of goods sold).

$$COGS = \text{Beginning inventory} + \text{Purchases} - \text{Ending inventory}$$

The identity can be solved for any of its four items, and exams do ask for purchases or beginning inventory.

The formulas differ only in which costs they say were sold first.

Assigning inventory costgoods available for sale = cost of sales + ending inventory

• Specific identification Use it actual cost of each unit; unique, high-value items
• First in, first out (FIFO) Memorize oldest costs to cost of sales, newest stay in inventory
• Weighted average cost Memorize one average unit cost for both
• Last in, first out (LIFO) Memorize newest costs to cost of sales, oldest stay in inventory; US GAAP only

• First in, first out (FIFO): the oldest costs go to cost of sales. Ending inventory carries the newest costs.
• Last in, first out (LIFO): the newest costs go to cost of sales. Ending inventory carries the oldest costs. Allowed under US GAAP only.
• Weighted average cost : one average cost per unit is used for both.
• Specific identification : each unit sold carries its own actual cost. It suits unique, high-value items such as jewelry or custom projects.

$$\text{Average cost} = \frac{\text{Cost of goods available for sale}}{\text{Units available for sale}}$$

The costs follow the formula, not the physical goods. A company can ship its oldest boxes and still report LIFO.

What happens to profit, tax and cash when costs rise?

LIFO reports higher cost of sales and lower profit than FIFO, pays less tax and keeps more cash. Weighted average lands between. Inflation in unit costs is what separates the formulas: with no change in costs, all three give the same answer.

Memorize

Item (costs rise, quantities stable or growing)	LIFO compared with FIFO
Cost of sales	Higher
Gross profit, operating profit, net income	Lower
Income taxes paid	Lower
Operating cash flow	Higher (lower taxes)
Ending inventory	Lower
Current ratio, working capital	Lower
Inventory turnover	Higher (higher cost of sales, lower inventory)
Days of inventory on hand	Lower
Gross and net margins	Lower
Debt-to-equity	Higher (lower retained earnings, so lower equity)
Return on assets	Unclear: lower profit and lower assets

LIFO compared with FIFOrising costs, stable or growing quantities; every effect flips when costs fall

• Higher Memorize
  • Cost of sales
  • Operating cash flow only because taxes are lower
  • Inventory turnover
  • Debt-to-equity
• Lower Memorize
  • Gross profit, operating profit, net income
  • Income taxes paid
  • Ending inventory, current ratio, working capital
  • Days of inventory on hand

The cash flow row is the one candidates miss. Lower profit does not create cash. The extra cost of sales is not a cash cost, since the company paid the same purchase prices either way, so the only cash difference is the tax.

$$\text{Tax saved} = (COGS_{LIFO} - COGS_{FIFO}) \times t$$

What changes when costs fall?

Everything reverses. With falling costs (deflation ) and stable or growing quantities, FIFO sends the old, dear costs to cost of sales, so FIFO shows lower profit and lower taxes than LIFO. Do not memorize a second grid. Flip the first.

Two points about which statement is “more realistic” are worth knowing. FIFO inventory is made of the newest purchases, so FIFO gives the better balance sheet. LIFO cost of sales is made of the newest purchases, so LIFO gives the better income statement, a profit closer to what replacing the goods costs today. Comparing a LIFO company with a FIFO peer therefore needs an adjustment.

Exam tip When the question says “rising prices”, the LIFO answer is the lower-profit, lower-tax, higher-cash answer. When it says “falling prices”, flip it. Do not rely on memory of which is which: ask which costs reach cost of sales.

How do you convert LIFO figures to FIFO?

Use the LIFO reserve. The LIFO reserve is the amount by which FIFO inventory would exceed LIFO inventory, disclosed by US companies using LIFO. It lets an analyst compare a LIFO company with a FIFO or IFRS peer.

Use it

$$Inventory_{FIFO} = Inventory_{LIFO} + \text{LIFO reserve}$$

$$COGS_{FIFO} = COGS_{LIFO} - (\text{Reserve}_{end} - \text{Reserve}_{start})$$

When costs rise, the reserve grows, so FIFO cost of sales is lower than LIFO cost of sales by the increase. Cumulative extra profit under FIFO also sits in equity, after tax.

$$Equity_{FIFO} = Equity_{LIFO} + \text{LIFO reserve} \times (1 - t)$$

A falling reserve is a signal. If a LIFO company sells more units than it buys, old, cheap layers flow into cost of sales. That LIFO liquidation temporarily inflates profit and gross margin, and it cannot be repeated once the layers are gone. US GAAP requires disclosure of income from liquidating LIFO inventory. If inventories fall but the reserve still rises, read it as rising costs rather than a liquidation, and confirm in management’s discussion.

Go deeper LIFO liquidation in numbers

A company holds an old LIFO layer of 10 units at 8. This year it buys 100 units at 20 and sells 110. Cost of sales under LIFO is 100 × 20 + 10 × 8 = 2,080, instead of 110 × 20 = 2,200 if it had restocked. The 120 difference, 10 × (20 − 8), is profit that comes only from selling old stock at old costs. The company pays tax on it and cannot repeat it. An analyst strips it out before extrapolating margins.

Go deeper Periodic versus perpetual systems

A periodic system counts inventory and computes cost of sales at period end. A perpetual system updates the records at every sale. The periodic and perpetual inventory systems give the same results for FIFO and specific identification. They can differ for LIFO and weighted average.

Example: 10 units at 5 on hand, 10 bought at 6, then 10 sold, then 10 bought at 8, then 5 sold. Periodic LIFO treats all 15 sales as coming from the newest layers: 10 × 8 + 5 × 6 = 110. Perpetual LIFO matches each sale to the layers on hand at the time: 10 × 6 + 5 × 8 = 100. FIFO is 80 either way (10 × 5 + 5 × 6). The rising-cost conclusions still hold in both systems.

Go deeper Why LIFO is banned under IFRS, and the US conformity rule

IFRS regulators object that LIFO leaves stale costs on the balance sheet and invites liquidation games. In the United States, a company that uses LIFO for its tax return must use LIFO in its financial statements too (the conformity rule). That is why the tax saving is real, and why the income taxes module returns to deferred taxes when book and tax methods differ.