The problem
When identical items are bought at different prices, a business must decide which costs go to COGS (the income statement) and which stay in ending inventory (the balance sheet). The total cost of goods available for sale is split between the two:
Cost of goods available = COGS + Ending inventory
The three common methods
- FIFO (first-in, first-out): assumes the oldest units are sold first. COGS uses old costs; ending inventory holds the newest costs.
- LIFO (last-in, first-out): assumes the newest units are sold first. COGS uses recent costs; ending inventory holds the oldest. LIFO is allowed under US GAAP but not under IFRS.
- Weighted average: uses one average cost per unit = total cost of goods available ÷ total units available.
These are cost-flow assumptions. They need not match the physical movement of goods.
Worked example
A store has these purchases of one product, and sells 250 units during the period.
| Layer | Units | Unit cost | Cost |
|---|---|---|---|
| Beginning inventory | 100 | $10 | $1,000 |
| Purchase 1 | 200 | $12 | $2,400 |
| Purchase 2 | 100 | $14 | $1,400 |
| Available | 400 | $4,800 |
Units left = 400 − 250 = 150.
FIFO. The 250 sold are the oldest: 100 × $10 + 150 × $12 = 1,000 + 1,800 = $2,800 COGS. Ending inventory: the last 50 of purchase 1 and all of purchase 2 = 50 × 12 + 100 × 14 = 600 + 1,400 = $2,000. Check: 2,800 + 2,000 = 4,800. ✓
LIFO. The 250 sold are the newest: 100 × $14 + 150 × $12 = 1,400 + 1,800 = $3,200 COGS. Ending inventory: 100 × 10 + 50 × 12 = $1,600. Check: 3,200 + 1,600 = 4,800. ✓
Weighted average. Average cost = 4,800 / 400 = $12. COGS = 250 × 12 = $3,000. Ending inventory = 150 × 12 = $1,800. ✓
What the choice does
When prices are rising (as here):
| FIFO | Weighted avg | LIFO | |
|---|---|---|---|
| COGS | lowest | middle | highest |
| Gross profit and net income | highest | middle | lowest |
| Ending inventory value | highest | middle | lowest |
Because LIFO gives lower profits in rising markets, it also lowers taxable income, which is why some firms choose it. When prices fall, the pattern reverses.
Lower of cost and net realisable value
Inventory should not be carried above what it can be sold for. If net realisable value (selling price minus selling costs) drops below cost, the inventory is written down and the loss is recognised.
Inventory errors
If ending inventory is overstated by $5,000, COGS is understated by $5,000 and net income is overstated by $5,000 in that year. The error reverses next year, because that year's beginning inventory is too high.
Common mistakes
- Mixing up which layers remain in ending inventory.
- Forgetting the total cost available must equal COGS plus ending inventory.
- Thinking the method must follow the physical flow of goods.