FIFO, LIFO & Average: A Simple Guide to Inventory Costing Methods

Every business wants to run smoothly. It wants happy customers who come back. It also wants steady profits. A regular flow of inventory helps make this happen. To keep products in stock and report finances correctly, companies must count and value the goods they plan to sell. This is important for financial reports and taxes. The good news is that inventory can help. Accounting software tracks inventory levels, manages orders, balances budgets, lists products and estimates future profits. There is no single way to calculate inventory costs. Businesses can choose from four methods. These are first in, first out (FIFO); last in, first out (LIFO); average cost; and specific identification. The right method depends on the type of products a company sells. It also depends on the goals and preferences of the management team.

Why Does Inventory Matter?

Before looking at the four methods, it helps to understand why inventory matters. It also explains why good accounting practices and accounting are important. Inventory is the list of products a business plans to sell. Keeping this list accurate and up to date is critical. It helps a business operate smoothly and avoid costly mistakes. The value of inventory can change over time. Costs can rise or fall based on production expenses, customer demand and market conditions. Knowing what items you have and how much they are worth helps you make better decisions and reach your business goals.

Inventory can be simple or complex. Some businesses sell one type of product, such as only shirts. This is standard inventory. Other businesses sell many products, like shirts, pants and shoes. These items often have different costs and values. Some products also have a limited shelf life. Food is a common example. These items must be sold in a specific order to avoid spoilage. Whether inventory is standard or varied, different costs affect profit margins. That is why tracking inventory correctly is so important.

Differences in Accounting Inventory Costing Methods

To choose the right inventory costing method, managers need to understand how each option works. Each method records inventory costs in a different ways. These differences affect financial reports, taxes and profit analysis. By knowing how the four inventory costing methods compare, businesses can better track costs, analyze performance and make informed financial decisions.

First in, first out (FIFO)

Most businesses use the “first in, first out” (FIFO) method. Products are assumed to sell in the order they're added to the inventory, meaning the first products in stock are the first to be sold. The FIFO method makes the most sense for businesses such as restaurants, bakeries and butchers because the products have a shelf life.

Last In, First Out (LIFO)

Last in, first out (LIFO) is the opposite of FIFO. With LIFO, the newest items added to inventory are sold first. Older items stay in stock longer. Fewer businesses use this method. Some businesses with many different products may use LIFO. Examples include grocery stores, drugstores and convenience stores. Many of their products expire, and prices often rise over time. Newer items usually cost more, while older items may be worth less.

A clothing company may also sell newer seasonal styles first. Older items are sold later, often at discounts, to attract buyers. This helps clear old stock and prevents the business from holding too much outdated inventory.

Average Cost

Average cost is another common inventory accounting method. It is often used by manufacturing, pharmaceutical and fuel companies. These businesses use a weighted average to track inventory value. With this method, all products are averaged together. The company calculates one average cost for all items in stock. This makes inventory tracking simple and easy. Management uses this average value to determine the total inventory cost.

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What Is Average Inventory and How to Calculate It?

Specific identification

If it's possible to know the exact amount of physical goods and how much each item costs at various points in time, then specific identification is the most accurate way to determine the accounting for inventory. Serial numbers are used to identify each product in the inventory to track, analyze and value the product over time. The specific identification method is often used for large items like furniture or vehicles, because their value changes over time, depending on the manufacture dates, models and other specifications.

What is the end goal?

The goal of accounting and taking inventory is to ultimately determine the cost of goods sold, which is an inventory of the products a company has sold during a particular period like a month, quarter or year. Management calculates the cost of goods sold through proper accounting during their set time:

Beginning Inventory + Purchases of New Products = Available Products to Sell

Available Products to Sell - Ending Inventory = Cost of Goods Sold

When a business knows its expenses, it can better predict revenue. These expenses include inventory, operating costs, material costs and taxes. By subtracting expenses from sales revenue, the company can calculate its profit margin as a percentage.

Companies that use accounting along with inventory costing methods gain a clearer view of business performance. This insight helps them make better decisions and improve both business and marketing strategies.

Conclusion

Inventory costing methods play a key role in how a business tracks stock, reports finances and plans for growth. Whether a company uses FIFO, LIFO, average cost or specific identification, the goal is the same: to understand inventory value accurately. Choosing the right method depends on the type of products sold, pricing changes and management needs. When combined with accounting software, these methods help businesses control costs, improve profitability and make smarter financial decisions.

Frequently Asked Questions (FAQs)

1. Which inventory costing method is best for most businesses?

FIFO is the most commonly used method. It works well for businesses that sell perishable or fast-moving goods and provides a clear picture of inventory value.

2. Can a business change its inventory costing method?

Yes, a business can change methods. However, it must follow accounting rules and clearly report the change, as it can affect taxes and financial statements.

3. How does inventory costing affect taxes?

Inventory costing impacts cost of goods sold (COGS), which affects taxable income. Some methods may lower reported profits in times of inflation, reducing tax liability.

4. Why is accounting software important for inventory costing?

Accounting software automates calculations, reduces errors and provides real-time inventory data. This makes inventory tracking and financial reporting more accurate and efficient.

5. Is specific identification suitable for small businesses?

It can be, but only if the business sells high-value or unique items. For most small businesses with large volumes of similar products, FIFO or average cost is easier to manage.