The same physical goods — three completely different profit numbers. The choice of inventory cost-flow assumption shapes margins, taxes, and what the balance sheet actually shows. Libby's Chapter 7 and AMS Chapter 13 trace every method from first principles with complete numerical examples.
Before choosing a cost-flow method, companies must choose how to track inventory quantities. The perpetual system updates inventory records continuously with every purchase and sale — the way a modern barcode-scanner point-of-sale system works. The balance sheet always shows a current inventory balance, and COGS is recorded with each sale. The periodic system counts inventory at the end of each accounting period (physical count) and calculates COGS from the COGS equation: Beginning Inventory + Purchases − Ending Inventory = COGS.
| Dimension | Perpetual System | Periodic System |
|---|---|---|
| Record keeping | Continuous — every transaction updates inventory | Only at period-end after physical count |
| COGS timing | Recorded at each sale | Calculated at end of period from COGS equation |
| Balance sheet accuracy | Current at all times | Only accurate after physical count |
| Used by | Retailers with scanners, large manufacturers | Small businesses, restaurants with high-volume SKUs |
| Shrinkage detection | Immediately visible (book vs. physical count) | Only revealed at period-end count |
A perpetual system continuously tracks every unit — so if the physical count at year-end shows 950 units but the book shows 1,000, the 50-unit discrepancy (shrinkage due to theft, damage, or counting error) is immediately visible and quantifiable. A periodic system can't detect shrinkage between counts — the COGS equation simply absorbs missing inventory into COGS, effectively hiding shrinkage. Companies with high shrinkage risk (retail, warehouse operations) almost always use perpetual systems.
Suppose a retailer buys 100 units of a product in January at $10 each, then buys another 100 units in March at $14 each when supplier prices rise. By June, the retailer has sold 150 units. Here's the problem: which units were sold — the $10 ones or the $14 ones?
Physically, you often can't tell. The product sitting in the warehouse is identical regardless of when it was purchased. Accounting needs an assumption — a cost-flow method — to decide which cost goes to the income statement (Cost of Goods Sold) and which stays on the balance sheet (ending inventory). The method you choose produces materially different profit numbers from the same underlying transactions.
Under U.S. GAAP, companies may choose any of three methods: First-In, First-Out (FIFO); Last-In, First-Out (LIFO); or Weighted Average Cost. Once chosen, the method must be applied consistently — companies cannot switch year to year to optimize their reported results. Note: LIFO is not permitted under IFRS, which is used by most non-U.S. companies.
FIFO vs LIFO vs Weighted Average — Same Goods, Different Numbers
Scenario: 100 units @ $10 + 100 units @ $14 purchased · 150 units sold · Prices rising
Total cost of goods available for sale (both methods, same goods)
$2,400 — 200 units (100 @ $10 + 100 @ $14)
FIFO
First-In, First-Out
COGS
$1,700
Ending Inv.
$700
Gross Profit
$700
29% margin
Higher taxes
Old (cheap) units expensed → higher profit
Weighted Avg
Average Cost
COGS
$1,800
Ending Inv.
$600
Gross Profit
$600
25% margin
Moderate taxes
Blended average cost per unit
LIFO
Last-In, First-Out
COGS
$1,900
Ending Inv.
$500
Gross Profit
$500
21% margin
Lower taxes
New (expensive) units expensed → lower profit
The Trade-Off — Rising Price Environment
FIFO: Better-looking P&L
Higher gross profit, current-cost inventory on balance sheet — but higher tax bill.
LIFO: Real cash savings
Lower reported profit, stale inventory on balance sheet — but genuine tax deferral.
Figure 1.1 — Three methods, same goods, three different outcomes. Revenue from selling 150 units at $16 = $2,400. Total cost available = $2,400. The split between COGS and ending inventory is what changes.
FIFO assumes the oldest inventory is always sold first. This mirrors how most businesses physically operate — a grocery store rotates stock so older milk is sold before newer milk. Under FIFO, the cost of the oldest units flows to Cost of Goods Sold, and the newest units remain in ending inventory.
| Units | Cost/Unit | Total | |
|---|---|---|---|
| COGS — first 100 units (oldest) | 100 | $10 | $1,000 |
| COGS — next 50 units | 50 | $14 | $700 |
| Total COGS | 150 | — | $1,700 |
| Ending inventory (50 units remain) | 50 | $14 | $700 |
In a period of rising prices, FIFO produces lower COGS (because older, cheaper units are expensed first) and higher gross profit. The balance sheet shows ending inventory at the most current, highest cost — which is closest to replacement cost and therefore most meaningful to analysts.
Higher gross profit means higher taxable income. Companies using FIFO pay more taxes in inflationary environments. This is why many U.S. companies historically chose LIFO — the tax deferral benefit was real and substantial.
LIFO assumes the newest inventory is sold first. This rarely reflects physical reality — actual inventory doesn't stack up like a pile where you always take from the top. But it is a valid accounting assumption under U.S. GAAP, and it produces a very different set of numbers.
| Units | Cost/Unit | Total | |
|---|---|---|---|
| COGS — last 100 units (newest) | 100 | $14 | $1,400 |
| COGS — next 50 units | 50 | $10 | $500 |
| Total COGS | 150 | — | $1,900 |
| Ending inventory (50 units remain) | 50 | $10 | $500 |
In rising prices, LIFO produces higher COGS ($1,900 vs. $1,700 under FIFO) and lower gross profit — and therefore lower taxable income. This is the appeal: genuine tax deferral. The downside is that the balance sheet's inventory figure ($500) reflects very old, very cheap costs that may be decades out of date.
Companies using LIFO are required to disclose a 'LIFO reserve' — the difference between what inventory would be under FIFO and what it is under LIFO. If a company reports inventory of $500M but its LIFO reserve is $180M, its inventory would be $680M under FIFO. When comparing a LIFO company to a FIFO company, analysts add the LIFO reserve to inventory and adjust retained earnings and COGS accordingly. Without this adjustment, the comparison is meaningless.
The weighted average method calculates a single blended cost per unit across all inventory available for sale, then applies that cost to both units sold and units remaining.
Weighted Average Cost Per Unit
Average Cost = Total Cost of Goods Available ÷ Total Units Available
Applied to both COGS and ending inventory.
| Units | Cost/Unit | Total | |
|---|---|---|---|
| Beginning inventory | 100 | $10 | $1,000 |
| Purchase | 100 | $14 | $1,400 |
| Goods available for sale | 200 | $12 avg | $2,400 |
| COGS (150 units × $12) | 150 | $12 | $1,800 |
| Ending inventory (50 units × $12) | 50 | $12 | $600 |
Weighted average produces results between FIFO and LIFO — COGS of $1,800 vs. $1,700 (FIFO) and $1,900 (LIFO). It's commonly used in industries where individual units are indistinguishable, such as grain, oil, or bulk chemicals.
Regardless of cost-flow method, how efficiently a company converts inventory into sales is measured by inventory turnover and days inventory outstanding (DIO). These metrics reveal whether inventory is moving at a healthy rate or piling up — a leading indicator of markdowns, write-downs, and demand problems.
Inventory Turnover
Inventory Turnover = COGS ÷ Average Inventory
Average inventory = (Beginning + Ending) ÷ 2. Use COGS, not revenue, to avoid method differences.
Days Inventory Outstanding (DIO)
DIO = 365 ÷ Inventory Turnover
How many days, on average, inventory sits before being sold. Compare within industry — structural differences across industries are large.
A LIFO company's inventory denominator is understated (old cheap costs), so its calculated inventory turnover appears higher and DIO appears lower than a FIFO peer — even with identical actual inventory velocity. Always use FIFO-equivalent inventory (add back LIFO reserve) when comparing inventory turnover across companies using different methods.
When comparing two companies in the same industry, confirm which inventory method each uses. A LIFO retailer and a FIFO retailer can report dramatically different gross margins even with identical underlying economics. The LIFO company's margin looks worse — but its tax bill is lower, which means more actual cash generation.
Many U.S. auto dealerships use LIFO because vehicle prices have historically risen over time. Using LIFO matches the most recently purchased (higher-cost) vehicles to current sales, reducing reported profit and tax. The LIFO reserve at a large dealer group can be hundreds of millions of dollars — inventory on the balance sheet could be understated by that amount relative to current market value.
Key Takeaways
A company uses LIFO in a period of steadily rising prices. Compared to FIFO, its LIFO financial statements will show: