Inventory Accounting Methods Explained: FIFO vs LIFO vs Weighted Average

Thinking Ledger
7 days ago
3 min read

Inventory accounting is more than just numbers—it affects your cost of goods sold (COGS), taxes, profitability, and even your cash flow. For founders and small business owners, especially in product-based startups (retail, DTC, manufacturing), understanding these methods can lead to smarter business decisions.

Why Inventory Accounting Matters

Inventory is one of the largest current assets for businesses dealing in physical goods. How you account for it directly impacts:

Net income (via COGS)
Gross margins
Taxable income
Inventory valuation on the balance sheet

Your chosen method can make the same company look more or less profitable depending on market conditions (e.g., inflation or deflation in material costs).

The 3 Major Inventory Accounting Methods

1. FIFO – First In, First Out

Definition: The oldest inventory items (first bought) are sold first.

Best For: Startups where inventory becomes obsolete or expires (e.g., food, cosmetics, electronics).

Impact:

In times of rising prices, FIFO
Results in lower COGS
Higher net income
Higher taxes
Ending inventory reflects newer, higher-cost items

Example:

Purchase Date	Units	Cost per Unit
Jan 1	100	$10
Jan 10	100	$12

If you sold 100 units, FIFO assumes you're selling the $10 ones. COGS = 100 × $10 = $1,000 Inventory = 100 × $12 = $1,200

2. LIFO – Last In, First Out

Definition: The most recent inventory items are sold first.

Allowed in US GAAP: ✅ Allowed in IFRS: ❌ (IFRS prohibits LIFO)

Best For: Companies that want to reduce taxable income during inflationary times (but watch out for tax audits!).

Impact:

In rising prices, LIFO
Results in higher COGS
Lower net income
Lower taxes
Ending inventory reflects older, cheaper items

Same Example:

COGS = 100 × $12 = $1,200 Inventory = 100 × $10 = $1,000

3. Weighted Average Cost (WAC)

Definition: Costs are averaged across all units.

Formula:

Weighted Average Cost per Unit = (Total Cost of Inventory) / (Total Units Available)

Best For: Businesses with large volumes of similar items (e.g., hardware, raw materials, eCommerce sellers with low SKU variation)

Impact:

Smooths out cost fluctuations
Simple to apply using software (e.g., QuickBooks, Xero, NetSuite)

Example:

Total Units: 200 (100 at $10 + 100 at $12)
Total Cost: $1,000 + $1,200 = $2,200
Average Cost per Unit = $2,200 / 200 = $11
Sell 100 units → COGS = 100 × $11 = $1,100 Inventory = 100 × $11 = $1,100

Accounting Standards to Know

GAAP Reference: ASC 330 – Inventory
IFRS Reference: IAS 2 – Inventories
GAAP allows FIFO, LIFO, WAC
IFRS allows FIFO and WAC, but not LIFO

Visual Snapshot: Comparison Table

Method	COGS (Rising Prices)	Net Income	Inventory Value	Allowed by GAAP?	Allowed by IFRS?
FIFO	Low	High	High	✅	✅
LIFO	High	Low	Low	✅	❌
WAC	Moderate	Moderate	Moderate	✅	✅

Founder Tip: When Should You Switch Methods?

LIFO might help reduce taxable income, but creates compliance complexity.
FIFO is the most intuitive and preferred by investors for realistic asset valuation.
Weighted Average is ideal for simplicity if you're using accounting software to automate COGS.

⚠️ Note: You must be consistent in applying the method unless you get IRS approval to switch (Form 3115).

Real-World Anecdote

One DTC fashion startup initially used FIFO and showed high profitability during early growth. But due to rising fabric costs, their margins looked inflated. After shifting to weighted average using NetSuite’s inventory module, their COGS stabilized, and they avoided confusion during their seed round fundraising.

Takeaway

Choosing the right inventory accounting method is both a financial and strategic decision. It affects taxes, profit margins, and even investor perception. Make sure you: