FIFO vs LIFO vs weighted average, on one worked example

The three methods in one sentence each

• FIFO: the units sold come from the oldest layers. Ending inventory is valued at the most recent costs.
• LIFO: the units sold come from the newest layers. Ending inventory keeps the oldest costs, sometimes from years ago.
• Weighted average: cost of goods available ÷ units available gives one cost per unit, used for both COGS and ending inventory.

Whatever the method, the total is fixed: cost of goods available = COGS + ending inventory. The method only decides how that total is split between this year's income statement and the balance sheet. The cash spent on stock is exactly the same.

Step 1: cost layers and units sold

The drill retailer starts the year with 100 drills at $60 and buys four more lots at rising prices: 150 at $62, 200 at $65, 150 at $68 and 100 at $70. That is 700 units with a cost of goods available of $45,500. The year-end count finds 180 drills on the shelf, so in a periodic system units sold = 700 − 180 = 520.

To allocate the 520 units to layers in Excel, take from each layer at most what it holds and never more than is still missing. For FIFO, starting at the top: =MIN(B2,$B$10-SUM(D$1:D1)), copied down. The growing range adds up what the layers above already gave. For LIFO, the same idea from the bottom up: =MIN(B5,$B$10-SUM(E6:E$6)). The check row must show 520 in both columns.

Step 2: COGS, ending inventory and gross profit

Value the units each layer gave with =SUMPRODUCT(unit costs, units sold):

• FIFO COGS = 100 × $60 + 150 × $62 + 200 × $65 + 70 × $68 = $33,060, ending inventory $12,440
• Weighted average: $45,500 ÷ 700 = $65.00 per unit, COGS = 520 × $65 = $33,800, ending inventory $11,700
• LIFO COGS = 100 × $70 + 150 × $68 + 200 × $65 + 70 × $62 = $34,540, ending inventory $10,960

At $99 a drill, revenue is $51,480 under every method, so gross profit is $18,420, $17,680 and $16,940. The difference between FIFO and LIFO inventory, $1,480, is the LIFO reserve, which US companies on LIFO disclose so that readers can restate the numbers to FIFO. Gross margin moves with it, which matters for ratios like the ones in markup vs margin.

Worked example: 520 cordless drills sold, three cost methods

Purchases, the year-end count and the selling price are yellow inputs. Columns D and E allocate the units sold to the layers for FIFO and LIFO, and the bottom table compares the three methods.

Worked example: 520 cordless drills sold, three cost methods

	A	B	C	D	E
1	Cost layer	Units	Unit cost ($)	FIFO units sold	LIFO units sold
2	1 Jan · opening stock	100	60.00	100	0
3	12 Feb · purchase	150	62.00	150	70
4	8 May · purchase	200	65.00	200	200
5	19 Aug · purchase	150	68.00	70	150
6	4 Nov · purchase	100	70.00	0	100
7	Total	700		520	520
8
9	Units counted on 31 Dec	180
10	Units sold	520
11	Selling price per drill ($)	99.00
12	Cost of goods available ($)	45,500.00
13	Weighted average unit cost ($)	65.00
14
15	Method	COGS ($)	Ending inventory ($)	Gross profit ($)
16	FIFO	33,060	12,440	18,420
17	Weighted average	33,800	11,700	17,680
18	LIFO	34,540	10,960	16,940
19	LIFO reserve (FIFO − LIFO inventory)		1,480

Fictional retailer and prices. General education on inventory accounting, not tax or accounting advice.

Which method is allowed where?

Under IFRS (IAS 2), only FIFO and weighted average are allowed for interchangeable items. LIFO is prohibited. Under US GAAP, LIFO is allowed, and its main attraction is tax: in rising prices it reports a lower profit and therefore a lower taxable income. The catch is the US LIFO conformity rule, under which a company that uses LIFO for tax must also use it in its financial statements, so it reports the lower profit to investors as well.

Once chosen, a method must be applied consistently. Switching from year to year to manage profit is not allowed, and a change of method needs a justification and disclosure. This guide is general education, not tax or accounting advice for a specific company.

Periodic versus perpetual

The example uses a periodic system: count at year end, then allocate. A perpetual system costs every sale when it happens. FIFO gives the same result in both. Weighted average becomes a moving average that is recalculated after every purchase, and perpetual LIFO can differ from periodic LIFO because a sale can only use layers that already existed on that date. Most retail and ERP systems run perpetual moving average or FIFO.

Whatever the method, inventory is also tested for impairment: if the net realisable value of an item falls below its cost, it is written down. And the inventory figure feeds days in inventory, part of the cash conversion cycle.

Common mistakes

• Averaging the unit costs without weights. AVERAGE of $60, $62, $65, $68 and $70 treats a 100-unit layer like a 200-unit one. Use cost of goods available ÷ units available.
• Forgetting the opening stock. The oldest layer under FIFO is last year's closing inventory. Leave it out and every number is wrong.
• Calculating ending inventory separately. Compute COGS, then ending inventory = goods available − COGS, so the two always add up.
• Using LIFO under IFRS. IAS 2 does not allow it. Only FIFO and weighted average (or specific identification) are permitted.
• Thinking the method changes cash. It only changes reported profit and, where taxes follow book profit, the tax bill.
• Mixing up periodic and perpetual LIFO. Perpetual LIFO can only use layers bought before each sale, so the results can differ.