Inventory Accounting: FIFO, LIFO and Weighted Average

Quick answer: Inventory accounting is how a business values the goods it holds for sale and decides which costs move to cost of goods sold when items are sold. The main inventory costing methods are FIFO (first in, first out), LIFO (last in, first out), weighted average and specific identification. The choice changes reported profit, taxes and the balance sheet when purchase prices change.

If you sell physical products, inventory is often your biggest asset and your biggest expense. Getting inventory accounting right decides whether your gross margin is real, whether your tax return is correct, and whether a lender trusts your balance sheet. This guide explains each inventory costing method with one worked example, compares perpetual and periodic systems, covers the IRS rules for small businesses, and lists the mistakes that distort profit.

What is inventory accounting?

Inventory accounting tracks the cost of goods you buy or make for resale, from purchase through sale. It answers two questions every period:

• What is the cost of the goods we sold? This becomes cost of goods sold (COGS) on the profit and loss statement.
• What is the cost of the goods still on hand? This becomes ending inventory, a current asset on the balance sheet.

The basic relationship is: Beginning inventory + Purchases - Ending inventory = Cost of goods sold. Inventory cost includes the purchase price plus costs to get goods ready for sale, such as inbound freight, duties and, for manufacturers, materials, direct labor and allocated overhead. Outbound shipping to customers is a selling expense, not inventory cost.

What are the main inventory costing methods?

Method	Which costs go to COGS first	Allowed under	Typical users
FIFO	Oldest costs	US GAAP, IFRS, IRS	Most retailers, food, perishables, ecommerce
LIFO	Newest costs	US GAAP and IRS (with Form 970 election); not IFRS	US businesses with steadily rising costs, such as some distributors and manufacturers
Weighted average	Average cost of all units available	US GAAP, IFRS, IRS	Interchangeable goods: fuel, grain, chemicals, bulk parts
Specific identification	Actual cost of each unit sold	US GAAP, IFRS, IRS	Cars, jewelry, art, custom furniture, high-value serialized items

Note that the method is a cost flow assumption. Under LIFO you can still physically ship your oldest stock first; the method only decides which costs are charged to COGS.

Worked example: FIFO vs LIFO vs weighted average

A small online store sells one product, a ceramic mug set. During the year:

Date	Event	Units	Cost per unit	Total cost
Jan 1	Beginning inventory	100	$10.00	$1,000
Apr 10	Purchase	200	$12.00	$2,400
Sep 5	Purchase	150	$14.00	$2,100
	Goods available for sale	450		$5,500

The store sold 300 units during the year at $25 each, for $7,500 of revenue, leaving 150 units at year end. Using a periodic system, the three methods give:

	FIFO	LIFO	Weighted average
COGS calculation	100 x $10 + 200 x $12	150 x $14 + 150 x $12	300 x $12.2222 ($5,500 / 450)
Cost of goods sold	$3,400	$3,900	$3,666.67
Ending inventory	$2,100 (150 x $14)	$1,600 (50 x $12 + 100 x $10)	$1,833.33
Check: COGS + ending	$5,500	$5,500	$5,500
Revenue	$7,500	$7,500	$7,500
Gross profit	$4,100	$3,600	$3,833.33
Gross margin	54.7%	48.0%	51.1%

Same sales, same purchases, same cash, but gross profit differs by $500 between FIFO and LIFO. Because costs rose during the year, LIFO charges the expensive recent units to COGS, lowering taxable profit. At an illustrative 21% corporate tax rate, that $500 difference is $105 of tax deferred this year. FIFO shows higher profit and a balance sheet inventory value closer to current replacement cost. When prices fall, the effects reverse.

Your method also affects ratios like gross margin and inventory turnover, so compare businesses only when they use the same method.

Perpetual vs periodic inventory systems

The costing method is separate from how often you update the records:

• Periodic system: you record purchases during the period and calculate COGS at the end after a physical count. Simple, common with spreadsheets, but you do not know COGS or stock levels in real time.
• Perpetual system: every sale and purchase updates inventory and COGS immediately, usually through point-of-sale, ecommerce or accounting software with inventory tracking. Better control, reorder alerts and faster month-end.

Under a perpetual system, LIFO and weighted average can produce slightly different numbers than in the periodic example above, because costs are assigned at the moment of each sale (moving average instead of an annual average). FIFO gives the same result under both. A simple inventory management spreadsheet works as a periodic system for a small catalog.

How the IRS treats inventory for small businesses

Tax rules for inventory follow the Internal Revenue Code and IRS Publication 538. Key points as of 2026:

• Small business exception: businesses that meet the gross receipts test (average annual gross receipts of $32 million or less for the prior three years, for tax years beginning in 2026, per the inflation adjustment in Rev. Proc. 2025-32) can use the cash method and are not required to keep inventories in the traditional way. They may treat inventory as non-incidental materials and supplies or follow the method used in their books.
• LIFO election: made by filing Form 970 with the tax return for the first year LIFO is used.
• LIFO conformity rule: if you use LIFO for tax, you generally must also use it in financial statements given to owners, creditors and lenders.
• Method changes: generally require filing Form 3115.

See IRS Publication 538, Accounting Periods and Methods, for details. This is general information, not tax advice; small businesses should confirm their eligibility and method with a tax professional.

How to set up inventory accounting: step by step

1. Decide what counts as inventory. Goods for resale, raw materials, work in process and finished goods; not office supplies.
2. Choose a costing method (FIFO is the usual default) and document it.
3. Choose periodic or perpetual tracking based on SKU count and sales volume.
4. Capitalize the right costs: purchase price, inbound freight, duties and handling.
5. Record purchases from supplier invoices and match them to purchase orders and receiving records.
6. Record sales with COGS, using journal entries such as debit COGS, credit inventory.
7. Count physically at least at year end, plus cycle counts during the year.
8. Adjust for shrinkage and obsolescence, and write down stock whose value has fallen below cost.
9. Review margins monthly by product to catch pricing or cost errors.

Journal entries for inventory: a simple example

Using the FIFO numbers from the mug example under a perpetual system, the store would record its purchases and sales like this (amounts shown for the April purchase and a sale of 100 units at $25):

Transaction	Debit	Credit	Amount
Buy 200 units on account at $12	Inventory	Accounts payable	$2,400
Sell 100 units on account at $25	Accounts receivable	Sales revenue	$2,500
Record cost of the 100 units sold (oldest layer, $10 each)	Cost of goods sold	Inventory	$1,000
Year-end count finds 2 units missing at $14	Inventory shrinkage (COGS)	Inventory	$28

In a periodic system, purchases go to a Purchases account during the year and a closing entry sets ending inventory and COGS after the count. Either way, the totals must reconcile: the inventory account in your general ledger should equal the value of your counted stock.

Inventory for manufacturers: raw materials, WIP and finished goods

Businesses that make products track three inventory stages:

• Raw materials: inputs not yet used, such as wood, fabric or ingredients.
• Work in process (WIP): partly finished goods, including materials, direct labor and overhead applied so far.
• Finished goods: completed products ready to sell.

Overhead, such as factory rent, equipment depreciation and utilities, is allocated to units produced, usually by labor hours or machine hours. Under the uniform capitalization (UNICAP) rules in Section 263A, larger businesses must also capitalize certain indirect costs into inventory for tax purposes; small businesses meeting the gross receipts test are exempt. If you depreciate production equipment, our guide on how to calculate depreciation explains the amounts you allocate.

Lower of cost or net realizable value: an example

Suppose 40 of the store's mugs, carried at $14 each ($560), have a printing defect and can only be sold for $9 each, with $1 per unit in selling costs. Net realizable value is $8 per unit, or $320. The store writes inventory down by $240 ($560 - $320) and records the loss, usually in COGS. Under US GAAP the write-down is not reversed if prices recover later. Checking for slow-moving and damaged stock each quarter keeps both your balance sheet and your margins honest.

How inventory affects working capital and ratios

Inventory is part of current assets, so it directly affects working capital and the current ratio, while the quick ratio excludes it because inventory is harder to turn into cash. Holding too much stock ties up cash that could pay suppliers or payroll; holding too little loses sales. Track days of inventory on hand (365 divided by inventory turnover) alongside gross margin by product, and reorder based on actual sell-through rather than gut feel.

Common inventory accounting mistakes

• Expensing all purchases immediately when you are required to keep inventories, which understates profit in growth years and overstates it later.
• Leaving out inbound freight and duties, which makes margins look better than they are. Tariffs matter here too.
• Skipping the year-end count, so ending inventory is a guess.
• Ignoring dead stock that should be written down.
• Switching methods casually without IRS consent.
• Pricing from purchase cost only instead of landed cost. Our guide on how to price a product uses landed cost.

Inventory accounting and your invoices

Inventory data and invoices are linked on both sides. Supplier invoices give you the cost layers that FIFO, LIFO and average methods depend on, so keep them with receiving records. Sales invoices record quantities shipped, which drive COGS in a perpetual system. Use consistent product names and SKUs on both. Our free invoice generator lets you add SKU-style item codes and quantities to each line, and our guide to calculating profit margin shows how to turn the results into pricing decisions.

Which inventory method suits ecommerce and multichannel sellers?

Online sellers often hold the same product in several places: a home garage, a third-party warehouse and a marketplace fulfillment center. FIFO with a perpetual system is usually the practical choice, because ecommerce platforms and inventory apps track stock by SKU and location and most support FIFO costing. Add landed costs to each purchase batch, including freight to the warehouse, duties and any prep fees, so marketplace fees are the only costs left to deduct from the selling price. Reconcile the platform's inventory reports with your own records monthly, because returns, damaged units and lost units in a warehouse are easy to miss until year end.

Inventory accounting does not need to be complicated: pick a method that fits your goods, track costs consistently, count regularly and review margins. The method you choose shapes reported profit and taxes, so set it up deliberately. When you sell that inventory, our invoice generator is free, needs no sign-up and downloads a clean PDF built right in your browser.