Inventory and Cost of Goods Sold: FIFO, LIFO and Weighted Average

If your business buys and sells products, inventory is often its largest asset and the hardest to control. How you value it determines your cost of goods sold, and therefore your gross profit and your taxes. In lesson 2 you saw that buying inventory isn't an expense; it becomes cost of goods sold (COGS) when it's sold. This lesson answers the next question: what did the units you sold actually cost, when you bought the same product at different prices?

Perpetual vs. periodic inventory

Periodic COGS = Beginning inventory + Purchases − Ending inventory (counted)

Even with a perpetual system you must count your stock regularly, at least once a year and ideally in rolling cycle counts. The gap between what the system says and what's on the shelf is shrinkage: theft, breakage, spoilage and recording errors.

The entries in a perpetual system

In its second year, Brightside Coffee starts selling 12-ounce bags of its house blend for $20. It buys 200 bags from its roaster at $12 each on account, then sells 50 bags for cash (we leave sales tax out to keep the focus on inventory):

Every sale creates two entries: one for the revenue, at the selling price, and one moving the goods out of inventory, at cost. The difference, $400, is the gross profit on that sale. Your point-of-sale system does this automatically, but only if each product's cost is set up correctly.

The real question: which cost goes out?

Prices change. If you bought bags at $10, then $12, then $13, what did the bags you sold cost? U.S. GAAP allows three main cost-flow assumptions for interchangeable goods:

• FIFO (first in, first out): the oldest units are assumed sold first. Ending inventory reflects recent prices.
• LIFO (last in, first out): the newest units are assumed sold first. Ending inventory reflects old prices.
• Weighted average: each unit sold is valued at the average cost of what's on hand (a moving average in a perpetual system).

The method is an accounting assumption; it doesn't have to match how you physically rotate stock. Brightside obviously sells its freshest beans last, but it could still choose LIFO for its books.

A full example: the inventory card

One month of Brightside's retail bag shelf:

• Beginning inventory: 100 bags at $10 = $1,000
• Purchase: 200 bags at $12 = $2,400
• Sale: 250 bags
• Purchase: 100 bags at $13 = $1,300
• Sale: 120 bags

Goods available for sale: $1,000 + $2,400 + $1,300 = $4,700 (400 bags). Brightside sold 370 bags, so 30 are left.

FIFO

COGS: $2,800 + $1,510 = $4,310. Ending inventory: $390.

LIFO (perpetual)

COGS: $2,900 + $1,500 = $4,400. Ending inventory: $300.

Moving weighted average

COGS: $4,326.67. Ending inventory: $373.33.

Here's the ending inventory each method leaves on the balance sheet:

With 370 bags sold at $20 ($7,400 of revenue), gross profit is $3,090 under FIFO, $3,073.33 under weighted average and $3,000 under LIFO. When prices rise, FIFO shows the most profit and LIFO the least. The $90 gap between FIFO and LIFO inventory is called the LIFO reserve; companies that use LIFO disclose it so readers can compare them with FIFO companies.

LIFO: a U.S. specialty with a tax angle

LIFO is permitted under U.S. GAAP but prohibited under IFRS, the standards used in most other countries. Its appeal is taxes: when costs rise, LIFO puts the newest, highest costs into COGS, which lowers taxable income. There's a catch known as the LIFO conformity rule: if you use LIFO on your tax return, you must also use it in the financial statements you give to owners and lenders. Electing LIFO for taxes is done with IRS Form 970, and switching methods later generally requires IRS consent. Whatever you choose, apply it consistently.

Inventory turnover: is it selling or sitting?

Inventory turnover = COGS ÷ Average inventory
Days in inventory  = 365 ÷ Turnover   (or 30 ÷ Turnover for a monthly figure)

In the example, average inventory for the month is ($1,000 + $390) ÷ 2 = $695, and monthly FIFO turnover is $4,310 ÷ $695 ≈ 6.2 times: a bag sits on the shelf about 5 days. That's excellent for fresh coffee. A furniture store or a hardware store would normally turn much more slowly. Compare yourself with your own history and with your industry.

Slow-moving inventory ties up cash, risks becoming obsolete and costs money to store and insure. Review items that haven't sold in months: discount them, stop reordering them or negotiate returns with the supplier.

Goods available = 40×$25 + 60×$30 + 50×$32 = $1,000 + $1,800 + $1,600 = $4,400

FIFO
Sell 70: 40×$25 + 30×$30 = $1,900         left 30×$30
Sell 45: 30×$30 + 15×$32 = $1,380         left 35×$32 = $1,120
COGS $3,280 · Ending inventory $1,120 · Total $4,400

LIFO (perpetual)
Sell 70: 60×$30 + 10×$25 = $2,050         left 30×$25
Sell 45: 45×$32 = $1,440                  left 30×$25 + 5×$32 = $910
COGS $3,490 · Ending inventory $910 · Total $4,400

Moving weighted average
After 1st purchase: $2,800 ÷ 100 = $28.00
Sell 70: 70×$28.00 = $1,960               left 30 units = $840
After 2nd purchase: ($840 + $1,600) ÷ 80 = $30.50
Sell 45: 45×$30.50 = $1,372.50            left 35 units = $1,067.50
COGS $3,332.50 · Ending inventory $1,067.50 · Total $4,400

Summary

• In a perpetual system, every sale has two entries: revenue at selling price and COGS at cost.
• FIFO expenses the oldest costs, LIFO the newest, and weighted average the mean cost on hand.
• COGS + ending inventory = beginning inventory + purchases, whatever the method.
• LIFO is a U.S. GAAP option that lowers taxable income when costs rise, but the conformity rule requires using it in your books too.
• Track turnover, count your stock and write down inventory worth less than its cost.

Next lesson: Adjusting Entries and Closing the Books. You'll record prepaid and accrued items, estimate bad debts and close Brightside's month the way a bookkeeper does.