**FIFO (First-In-First-Out)** assumes oldest inventory (first purchased) is sold first. **LIFO (Last-In-First-Out)** assumes newest inventory (most recently purchased) is sold first. **Neither method requires physical flow to match accounting flow** - purely accounting choices affecting financial statements and taxes. **FIFO Mechanics**: Company buys 100 units @ $10 (January), 100 units @ $12 (March), 100 units @ $15 (May).

Sells 150 units total.

FIFO assumes first 100 units sold cost $10 each, next 50 units cost $12 each. **COGS** = (100 × $10) + (50 × $12) = $1,000 + $600 = **$1,600**. **Ending inventory** (remaining 50 units from May batch + 50 from March): (50 × $12) + (50 × $15) = **$1,350**. **LIFO Mechanics** (same purchases, same 150 units sold): LIFO assumes newest inventory sold first.

First 100 units sold cost $15 each (May batch), next 50 units cost $12 each (March batch). **COGS** = (100 × $15) + (50 × $12) = $1,500 + $600 = **$2,100**. **Ending inventory** (remaining 50 units from March + 100 from January): (50 × $12) + (100 × $10) = **$1,600**. **Financial Statement Impact**: Revenue (same for both) = 150 units × $20 selling price = **$3,000**. **FIFO Gross Profit**: $3,000 - $1,600 COGS = **$1,400** (higher profit reported). **LIFO Gross Profit**: $3,000 - $2,100 COGS = **$900** (lower profit, matches current costs better). **Tax Impact** (21% corporate tax rate): **FIFO Tax**: $1,400 profit × 21% = **$294 tax owed**. **LIFO Tax**: $900 profit × 21% = **$189 tax owed**. **LIFO saves $105 in taxes** (27% tax reduction) because COGS is higher (matches recent higher costs), reducing taxable income.

This advantage exists **only during inflation** when costs rise year-over-year. **When to Use FIFO (Best for)**: (1) **Perishable goods/short shelf life**: Grocery stores, restaurants, pharmaceuticals.

Actual physical flow is FIFO (sell old stock before expiration), so accounting matches reality. (2) **Falling cost environment**: Electronics, technology hardware where component costs decrease over time.

FIFO results in higher COGS (older, more expensive inventory sold), **lower taxes**.

Opposite of typical scenario. (3) **Income statement emphasis**: Startups seeking investment, companies preparing for IPO, businesses maximizing reported earnings for bonuses/valuations.

FIFO shows **higher gross profit**, stronger margins, better ratios (ROA, ROE, profit margin).

Investors/lenders prefer. (4) **International operations**: IFRS (International Financial Reporting Standards) **prohibits LIFO**, so multinational companies use FIFO for global consistency (U.S. allows LIFO, but creates reconciliation burden if using different methods domestically vs abroad). (5) **Consistent/stable costs**: If purchase prices don't fluctuate significantly year-to-year (+/- 5% max), FIFO vs LIFO results are nearly identical.

FIFO is simpler to administer (no LIFO reserve tracking, fewer IRS complications). **When to Use LIFO (Best for)**: (1) **Inflationary environment (most common 2025 use case)**: When costs rising 5-15%+ annually.

LIFO matches newest (higher) costs to revenue, **reducing taxable income 15-30%** vs FIFO.

Tax savings justify administrative complexity.

Industries: Manufacturing (steel, aluminum, lumber costs volatile), retail (apparel, home goods with tariff impacts), oil/gas (commodity price swings). (2) **Tax minimization priority**: Privately-held companies not seeking external investment, where tax savings >> need for high reported earnings.

Cash flow from tax savings can be reinvested into business (inventory, equipment, payroll). (3) **High-volume, non-perishable inventory**: Retailers with 10,000+ SKUs of shelf-stable goods (hardware stores, auto parts, bulk commodity traders).

Physical flow doesn't matter (inventory doesn't expire), so can use LIFO for tax benefit without operational mismatch. (4) **Long-term inventory holdings**: Companies maintaining large base-stock levels year-over-year (warehouses, distributors).

LIFO creates "LIFO layers" that remain on books at historical cost (old inventory from 1980s/1990s at $1-5/unit still on balance sheet if never depleted).

Provides permanent tax deferral vs FIFO which constantly inflates inventory values. **2025 Economic Context (Inflation Era)**: **Post-2021 inflation surge**: Consumer prices up 20%+ cumulative 2021-2024, business input costs up 15-40% (materials, labor, freight).

Companies using FIFO saw taxable income spike 25-50% despite flat or declining real margins (revenue rose with prices, but FIFO COGS reflected old, cheap inventory costs → artificial profit boost → higher taxes). **Example**: Furniture retailer, 2020 average cost $500/sofa, 2024 average cost $700/sofa (+40% due to lumber, foam, labor inflation).

Sells 1,000 sofas/year at $1,200 each. **FIFO 2024**: Sold sofas cost avg $550 (mix of old 2020-2023 inventory + some 2024).

COGS $550k, Revenue $1.2M, Profit $650k, Tax (21%) = **$136,500**. **LIFO 2024**: Sold sofas cost avg $690 (mostly 2024 purchases).

COGS $690k, Revenue $1.2M, Profit $510k, Tax (21%) = **$107,100**. **LIFO tax savings: $29,400** (21.5% reduction) on same actual business operations. **Over 5 years of inflation, cumulative LIFO tax savings could be $150k-300k for mid-size business** ($5-20M revenue). **Regulatory Considerations**: **IRS Section 472**: Companies **electing LIFO must use it for tax purposes AND financial reporting** (LIFO conformity rule).

Cannot use LIFO to IRS (pay less tax) while reporting FIFO to shareholders/lenders (show higher profit).

Exception: Can report "FIFO equivalent" earnings in footnotes via LIFO reserve reconciliation. **Switching costs**: Once elected, LIFO is difficult to abandon.

Reverting to FIFO requires recognizing **all deferred LIFO tax** in one year (LIFO reserve × tax rate = tax bill).

Example: $2M LIFO reserve × 21% = **$420k immediate tax**.

Companies trapped in LIFO unless willing to take massive one-time hit. **GAAP disclosure**: Must disclose LIFO reserve (difference between LIFO and FIFO inventory values) in 10-K footnotes, allowing analysts to adjust comparisons. **Weighted Average Method** (alternative to FIFO/LIFO): **How it works**: Averages all purchase costs, applies same average to COGS and ending inventory.

Example: Total purchases 300 units: 100 @ $10, 100 @ $12, 100 @ $15 = $3,700 total ÷ 300 units = **$12.33 average cost**.

Sold 150 units: COGS = 150 × $12.33 = **$1,850**.

Ending inventory 150 units: 150 × $12.33 = **$1,850**. **Pros**: Simple, no layers to track, smooths price volatility, falls between FIFO/LIFO extremes. **Cons**: Not allowed for tax purposes in U.S. (GAAP allows, but IRS doesn't), only used for internal management accounting or international reporting. **Decision Framework (2025)**: Choose **FIFO** if: High reported earnings needed (fundraising, loan covenants, management bonuses), International operations (IFRS compliance), Falling cost environment, Perishable inventory (operational necessity).

Choose **LIFO** if: Inflation environment (costs rising >5%/year), Tax minimization priority (privately held, cash flow focus), High inventory turnover (5-10× annually so LIFO layers manageable), Long-term U.S.-only operations (avoid international IFRS conflicts).

Choose **Weighted Average** if: Internal use only (not for IRS), Simplicity > precision, Moderate cost fluctuations. **Common Misconceptions**: ❌ "LIFO means we sell newest physical inventory first" - **False**.

Physical flow independent of accounting method.

Grocery store uses FIFO physically (sell old milk first) but could use LIFO accounting (tax purposes) if advantageous. ❌ "LIFO always saves taxes" - **False**.

Only saves when costs rising.

In deflation (costs falling), LIFO increases taxes vs FIFO.

Technology sector in 1990s-2000s had falling component costs, most used FIFO. ❌ "FIFO shows 'true' inventory value" - **Partially true**.

FIFO ending inventory closer to current replacement cost (newest purchases), but COGS reflects outdated old costs.

LIFO ending inventory understated (old costs), but COGS matches current economic reality better. ❌ "Can switch between FIFO/LIFO annually" - **False**.

IRS requires consistency, changing methods needs IRS approval (Form 3115) and triggers recapture of LIFO reserves (tax hit).

**FIFO COGS Calculation (Step-by-Step)**: **Given**: January 1 beginning inventory = 50 units @ $8 = $400.

Purchases during year: March 1 = 100 units @ $10, June 1 = 100 units @ $12, September 1 = 100 units @ $14.

Sales during year = 280 units sold @ $25 each. **Step 1**: Total units available for sale = 50 (beginning) + 100 + 100 + 100 = **350 units**. **Step 2**: Assign costs to COGS (280 units sold, FIFO order): Layer 1: 50 units @ $8 (beginning inventory, sold first) = **$400**.

Layer 2: 100 units @ $10 (March purchase, next oldest) = **$1,000**.

Layer 3: 100 units @ $12 (June purchase) = **$1,200**.

Layer 4: 30 units @ $14 (partial September purchase, first 30 of 100) = **$420**. **Total FIFO COGS** = $400 + $1,000 + $1,200 + $420 = **$3,020**. **Step 3**: Calculate ending inventory (350 available - 280 sold = **70 units remaining**).

Remaining inventory (FIFO): 70 units @ $14 (last 70 from September batch) = **$980 ending inventory**. **Step 4**: Income statement (FIFO).

Revenue: 280 units × $25 = **$7,000**.

COGS: **$3,020**.

Gross Profit: $7,000 - $3,020 = **$3,980**. **Step 5**: Tax liability (21% corporate rate).

Taxable income (assume GP = taxable income for simplicity): $3,980 × 21% = **$836 tax**. **LIFO COGS Calculation (Step-by-Step)**: **Step 1**: Same total units available = **350 units**. **Step 2**: Assign costs to COGS (280 units sold, LIFO order - newest first): Layer 1: 100 units @ $14 (September, most recent, sold first) = **$1,400**.

Layer 2: 100 units @ $12 (June, next newest) = **$1,200**.

Layer 3: 80 units @ $10 (partial March purchase, first 80 of 100) = **$800**. **Total LIFO COGS** = $1,400 + $1,200 + $800 = **$3,400**. **Step 3**: Calculate ending inventory (70 units remaining).

Remaining inventory (LIFO): 50 units @ $8 (beginning inventory, oldest layer untouched) = **$400**. 20 units @ $10 (last 20 from March batch) = **$200**. **Total ending inventory** = $400 + $200 = **$600**. **Step 4**: Income statement (LIFO).

Revenue: 280 units × $25 = **$7,000** (same as FIFO).

COGS: **$3,400**.

Gross Profit: $7,000 - $3,400 = **$3,600**. **Step 5**: Tax liability.

Taxable income: $3,600 × 21% = **$756 tax**. **FIFO vs LIFO Comparison Table**: | Metric | FIFO | LIFO | Difference | |--------|------|------|------------| | Revenue | $7,000 | $7,000 | $0 | | COGS | $3,020 | $3,400 | **+$380 LIFO** | | Gross Profit | $3,980 | $3,600 | **-$380 LIFO** | | Tax (21%) | $836 | $756 | **-$80 LIFO saves** | | Ending Inventory | $980 | $600 | **-$380 LIFO lower** | **Key Insights**: (1) **LIFO COGS $380 higher** because it matched newer, more expensive purchases ($12-14/unit) to sales vs FIFO which exhausted old cheap inventory first ($8-10/unit). (2) **LIFO Gross Profit $380 lower** (represents current period earning power better - if had to replace sold inventory today, would pay $14/unit, so LIFO margin more realistic). (3) **LIFO Tax savings $80** (9.6% tax reduction).

Over 10 years of continuous inflation, this compounds to $800-1,200 cumulative savings (reinvested becomes working capital). (4) **LIFO Ending Inventory $380 lower** (balance sheet shows old historical costs $8-10 vs FIFO $14).

Investors/lenders may view as understated assets, but tax savings offset. **Tax Savings Breakdown by Inflation Rate** (2025 scenarios): **Scenario A - Low Inflation (3% annual cost increase)**: Beginning inventory 1,000 units @ $50.

Year 1 purchases 10,000 units @ $51.50 (3% up).

Sell 10,000 units @ $100 each. **FIFO COGS**: (1,000 × $50) + (9,000 × $51.50) = $50,000 + $463,500 = **$513,500**. **LIFO COGS**: 10,000 × $51.50 = **$515,000**. **COGS Difference**: $1,500 higher LIFO. **Tax savings** (21%): $1,500 × 0.21 = **$315/year** (0.6% of revenue).

Minimal benefit, administrative burden may not justify LIFO. **Scenario B - Moderate Inflation (7% annual cost increase, typical 2022-2024)**: Beginning inventory 1,000 units @ $50.

Year 1 purchases 10,000 units @ $53.50 (7% up).

Sell 10,000 units @ $100 each. **FIFO COGS**: (1,000 × $50) + (9,000 × $53.50) = $50,000 + $481,500 = **$531,500**. **LIFO COGS**: 10,000 × $53.50 = **$535,000**. **COGS Difference**: $3,500 higher LIFO. **Tax savings**: $3,500 × 0.21 = **$735/year** (1.5% of $500k taxable income).

Meaningful savings, LIFO justified for most mid-large businesses. **Scenario C - High Inflation (15% annual cost increase, extreme commodities/tariffs)**: Beginning inventory 1,000 units @ $50.

Year 1 purchases 10,000 units @ $57.50 (15% up).

Sell 10,000 units @ $100 each. **FIFO COGS**: (1,000 × $50) + (9,000 × $57.50) = $50,000 + $517,500 = **$567,500**. **LIFO COGS**: 10,000 × $57.50 = **$575,000**. **COGS Difference**: $7,500 higher LIFO. **Tax savings**: $7,500 × 0.21 = **$1,575/year** (3.2% of $500k taxable income). **Substantial savings**, LIFO almost mandatory for tax efficiency unless seeking high reported earnings. **Compounded 5-Year Tax Savings** (Moderate Inflation 7% annually): Year 1 savings: $735.

Year 2: Inflation compounds, cost now $57.25 vs year 1 avg $51.50, delta widens → $1,100 savings.

Year 3: $1,550 savings (base layer from year 1 at $50 still on books, increasingly divergent from $61+ current costs).

Year 4: $2,150 savings.

Year 5: $2,900 savings. **Cumulative 5-year LIFO tax savings: $8,435** vs FIFO.

For $5M revenue company, this scales to **$80k-150k saved over 5 years** (available for capex, hiring, debt paydown). **LIFO Reserve Concept**: **LIFO Reserve** = Difference between FIFO inventory value and LIFO inventory value (always positive when costs rising).

From earlier example: FIFO ending inventory $980, LIFO ending inventory $600 → **LIFO reserve = $380**. **Economic meaning**: Cumulative tax deferral.

If liquidated LIFO layers (sold all inventory), would owe $380 × 21% = **$80 deferred tax**.

As long as inventory maintained or growing, tax deferred indefinitely (similar to tax-deferred retirement account - pay later, benefit from cash use now). **Large companies' LIFO reserves (2024 10-K examples)**: Walmart: **$2.8 billion LIFO reserve** (represents ~$588M deferred tax at 21%).

Home Depot: **$1.6 billion LIFO reserve** ($336M deferred tax).

ExxonMobil: **$8.5 billion LIFO reserve** ($1.8B deferred tax, oil/gas industry highly inflationary). **Annual LIFO reserve growth = annual tax savings**.

Walmart LIFO reserve increased $350M in 2024 → saved $350M × 21% = **$73.5M in taxes** that year vs if had used FIFO. **Practical Calculation Tips**: (1) **Use spreadsheet with layers**: Track each purchase batch separately (date, units, cost/unit, total).

Automate FIFO (sells from oldest layer first) vs LIFO (newest layer first) logic with formulas. (2) **Periodic vs Perpetual**: Periodic LIFO = calculate COGS once at year-end (simpler, used in example above).

Perpetual LIFO = recalculate after every sale (more accurate but complex, requires real-time layer tracking).

Most companies use periodic for simplicity. (3) **Dollar-Value LIFO** (advanced): Instead of unit-based layers, track inventory in dollars adjusted for price indices.

Avoids massive layer count problem (10,000 SKU retailer can't track unit layers for each).

IRS approved method for complex businesses. (4) **LIFO conformity rule compliance**: If reporting FIFO to shareholders for better earnings, must disclose LIFO reserve in footnotes allowing conversion (FIFO income = LIFO income + LIFO reserve increase × [1 - tax rate]). **Switching Between Methods**: **FIFO → LIFO**: File IRS Form 3115 (change in accounting method), typically approved if reasonable business justification (inflation, tax planning).

Takes effect **beginning** of year filed, cannot cherry-pick.

Example: File in 2025, applies Jan 1, 2025 onward.

No recapture tax (don't pay back past tax benefits). **LIFO → FIFO**: Also requires Form 3115, but must **pay tax on entire LIFO reserve** in year of switch (or spread over 4 years if qualifying).

Expensive.

Example: $5M LIFO reserve × 21% = **$1.05M tax bill**.

Rarely done unless (1) costs now falling (LIFO hurts), (2) seeking acquisition (buyers prefer FIFO for higher asset values), (3) going public/IFRS compliance. **2025 Strategic Recommendations**: **If already using FIFO and costs rising >5%/year**: Seriously consider switching to LIFO for tax savings (file Form 3115 early 2025 to apply to full year).

Savings can be 10-30% of tax bill annually. **If already using LIFO and costs stabilizing**: Stay on LIFO (switching back triggers massive recapture tax).

Even in low-inflation years, LIFO reserve provides balance sheet "hidden tax asset." **If starting new business in 2025**: Elect LIFO from day 1 if inventory-intensive and expecting growth (builds LIFO layers early at lower costs, maximizes future benefit).

Must make election on first tax return. **If considering acquisition/IPO within 3 years**: Use FIFO despite tax cost (deal multiples based on reported EBITDA, LIFO depresses earnings by 10-20%, costs $5-15M in valuation on $100M exit). **Authority**: IRS Publication 538 (Accounting Periods and Methods), IRC Section 471 (Inventory Methods), IRC Section 472 (LIFO Election), FASB ASC 330 (Inventory Accounting), IRS Revenue Procedure 2022-14 (LIFO conformity rules), 10-K disclosures Fortune 500 companies.