Inventory App Builder

Inventory valuation: FIFO, LIFO and weighted average explained with one example (2026)

FIFO, LIFO and weighted average cost worked through on the same year of purchases, with what each does to profit and tax, and the IRS and IFRS rules a small shop should know.

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Key Takeaways

  • The method changes profit, not cash. You paid suppliers the same amount whichever method you use. The method only decides how that cost is split between this year’s cost of goods sold and the stock you carry forward.
  • When prices rise, FIFO shows the highest profit. In the worked example, FIFO gives $2,300 gross profit, weighted average about $2,233 and LIFO $2,175 on the same sales.
  • LIFO is a US tax choice with paperwork. The IRS requires Form 970 to elect LIFO. IFRS (IAS 2) does not permit LIFO at all, while US GAAP does.
  • Many small businesses qualify for simpler treatment. The IRS small business taxpayer exception covers businesses with average annual gross receipts of $31 million or less for 2025, letting them skip keeping full tax inventories.
  • Damaged and out-of-date stock has its own rule. IRS Publication 538 lets you value goods you can’t sell at normal prices at their real selling price minus disposal costs, whatever method you use for the rest.

Quick-Start Prioritization Framework

MethodAssumes you sell…When prices riseWho typically uses it
FIFO (first in, first out)The oldest stock firstLower cost of goods sold, higher profit, stock valued near current pricesMost small shops; the most common default
Weighted averageA blend of everything on handIn between FIFO and LIFOShops with interchangeable items bought at varying prices
LIFO (last in, first out)The newest stock firstHigher cost of goods sold, lower taxable profitSome US businesses, for tax; not allowed under IFRS
Specific identificationThe exact unit you soldMatches actual cost of each itemOne-of-a-kind or high-value items

Inventory valuation decides two numbers on your books: the cost of the goods you sold this year, and the value of the stock still on your shelves. Prices you pay suppliers change through the year, so which purchase you treat as “sold” changes both numbers, and with them your gross profit and your taxable income. This guide works FIFO, LIFO and weighted average through one shop’s real-looking year of candle purchases, then covers the rules from the IRS and the international standard IAS 2 that limit your choice. It is general information, not tax or accounting advice; your accountant should confirm what applies to you.

Why the valuation method matters

Gross profit is sales minus cost of goods sold. Cost of goods sold is beginning inventory plus purchases minus ending inventory. Change the value you put on ending inventory and cost of goods sold moves by exactly the same amount in the other direction.

If you bought every unit at the same price, all methods give the same answer. They differ only because purchase prices move, which for most shops means they rise.

Cost flow is an assumption, not what happened on the shelf

You may physically sell the oldest candles first, because you rotate stock. You can still use weighted average for the books. The method describes how costs are assigned, not how boxes move.

What counts as cost

IRS Publication 538 says the cost of merchandise you buy is the invoice price less trade or other discounts, plus transportation and other charges incurred in acquiring the goods. Freight in is part of the cost of the stock, not a separate overhead.

The worked example: one shop, one year

A shop sells one candle. During the year it has the following stock and purchases, and sells 300 candles at $12 each, for $3,600 of sales.

DateEventUnitsCost per unitTotal cost
1 JanuaryBeginning inventory100$4.00$400
MarchPurchase200$4.50$900
JunePurchase150$5.00$750
Available for sale450$2,050
Through the yearSold300
31 DecemberEnding inventory150?

The question each method answers

$2,050 of cost is available. 300 units were sold and 150 remain. Each method decides how much of the $2,050 belongs to the 300 sold and how much to the 150 still on the shelf. The calculations below use the periodic approach, applying the method once at year end.

FIFO: first in, first out

FIFO assumes the oldest units are sold first, so the units left at year end are the most recently bought.

The calculation

The 300 units sold are the 100 from January at $4.00 and the 200 from March at $4.50. Cost of goods sold = $400 + $900 = $1,300.

Ending inventory is the 150 units from June at $5.00 = $750. Check: $1,300 + $750 = $2,050.

Gross profit = $3,600 − $1,300 = $2,300.

What it means for a shop

FIFO values your remaining stock close to what it would cost to replace today, which makes the balance sheet realistic. It matches how most shops physically rotate stock, which makes it intuitive. In a year of rising prices it shows the highest profit, and so, all else equal, the highest taxable income.

LIFO: last in, first out

LIFO assumes the newest units are sold first, so the oldest costs stay in ending inventory.

The calculation

The 300 sold are the 150 from June at $5.00 and 150 of the 200 from March at $4.50. Cost of goods sold = $750 + $675 = $1,425.

Ending inventory is the remaining 50 March units at $4.50 plus the 100 January units at $4.00 = $225 + $400 = $625. Check: $1,425 + $625 = $2,050.

Gross profit = $3,600 − $1,425 = $2,175, which is $125 less than FIFO.

Why anyone uses it

In a period of rising prices, LIFO matches recent, higher costs against sales, which lowers reported profit and, in the US, taxable income. KPMG’s 2026 comparison notes that companies using LIFO under US GAAP often do so for tax reasons.

The rules that come with it

In the US, you elect LIFO by filing IRS Form 970 with your return for the first year you use it. Publication 538 notes LIFO has complex rules, including dollar-value pooling, with a simplified dollar-value method available to eligible small businesses with average annual gross receipts of $5 million or less. Outside the US, LIFO is generally off the table: IAS 2, the IFRS standard on inventories, does not permit it.

Weighted average cost

Weighted average treats every unit available as having the same blended cost.

The periodic calculation

Average cost = $2,050 ÷ 450 units ≈ $4.5556 per unit. Cost of goods sold = 300 × $4.5556 ≈ $1,366.67. Ending inventory = 150 × $4.5556 ≈ $683.33. Check: $1,366.67 + $683.33 = $2,050.

Gross profit ≈ $3,600 − $1,366.67 = $2,233.33, between FIFO and LIFO.

The moving average version

Most inventory and POS software recalculates the average after every purchase, which is called moving or perpetual average. Each sale is costed at the average at that moment. If the shop sold 80 candles in February, before the March delivery, those 80 would be costed at $4.00, and the average would only rise after March. The yearly total will usually differ a little from the periodic figure, so use the same version every year.

When it fits

Weighted average suits stock that is truly interchangeable and bought in overlapping batches: coffee beans, yarn, screws, wax. It smooths out price swings and avoids tracking which batch each unit came from. IAS 2 permits it alongside FIFO for interchangeable items.

Side by side

The same purchases and the same sales, three different results.

FIFOWeighted averageLIFO
Sales$3,600$3,600$3,600
Cost of goods sold$1,300$1,366.67$1,425
Gross profit$2,300$2,233.33$2,175
Ending inventory$750$683.33$625
Cash paid to suppliers$1,650$1,650$1,650

Reading the table

Cash paid for this year’s purchases is identical across methods ($900 + $750). What changes is timing: under LIFO, $125 of cost is recognised this year that FIFO pushes into next year through a higher closing stock value. Over the life of the business the total cost recognised is the same; the methods differ in when.

If prices fall

Reverse the price trend and the ranking reverses too: FIFO shows the lowest profit and LIFO the highest. Choose a method for how well it reflects your business, not a guess about next year’s prices, because changing later takes paperwork.

The rules a small shop should know

These are the points that most often matter for a small retailer or workshop. They are summaries of the official sources listed below, not a substitute for advice on your own situation.

The IRS small business taxpayer exception

Publication 538 explains that a small business taxpayer that meets the gross receipts test can choose not to keep an inventory for tax, though it must still use a method that clearly reflects income, either treating inventory as non-incidental materials and supplies or following how it treats inventory in its financial statements or, without those, its books and records. The test is based on average annual gross receipts over the prior three years; the Taxpayer Advocate Service gives the inflation-adjusted limit for 2025 as $31 million. Tax shelters can’t use it.

Lower of cost or market, and net realisable value

Under IRS rules, you may value inventory at cost or at the lower of cost or market, applied item by item; goods accounted for under LIFO must be valued at cost. IAS 2 requires inventories to be measured at the lower of cost and net realisable value, meaning the estimated selling price minus the costs to complete and sell.

Damaged and shopworn goods

Publication 538 treats goods you can’t sell at normal prices because of damage, imperfections, shop wear, style changes or similar causes under a separate heading, goods that cannot be sold. You can value them at a bona fide selling price minus direct cost of disposition, whichever method you use for the rest of your inventory.

Changing methods

Changing your inventory method for tax is a change in accounting method and generally needs IRS Form 3115. Pick carefully at the start and talk to your accountant before switching.

Common mistakes

Most valuation problems in small shops come from the inputs, not the choice of method.

  • Leaving freight-in out of unit cost, which understates inventory and overstates margins.
  • Switching methods between years without telling your accountant or filing the paperwork.
  • Keeping damaged or obsolete stock at full cost long after it stopped being sellable at that price.
  • Assuming LIFO is always a tax win; it needs an election, carries extra rules, and helps only while costs rise.
  • Valuing inventory from the system number without a recent count, so the balance sheet carries stock that isn’t there.
  • Mixing periodic and moving average figures from different reports and wondering why they don’t match.

Frequently Asked Questions

Which inventory valuation method is best for a small business?

Many small shops use FIFO because it matches how they rotate stock and values inventory near current cost. Weighted average suits interchangeable goods bought in overlapping batches. Ask your accountant which fits your tax and reporting situation.

Is LIFO allowed?

In the US, yes, for tax and under US GAAP; you elect it with IRS Form 970. Under IFRS, IAS 2 does not permit LIFO.

Does FIFO or LIFO give a higher profit?

When purchase prices are rising, FIFO gives a higher reported profit and LIFO a lower one. When prices fall, the reverse is true. In this guide’s example FIFO showed $2,300 gross profit and LIFO $2,175.

How do I calculate weighted average cost?

Divide the total cost of all units available for sale by the number of units. In the example, $2,050 ÷ 450 ≈ $4.56 per unit. Multiply by units sold for cost of goods sold and by units left for ending inventory.

Do I have to keep inventory for tax purposes?

Not always. IRS Publication 538 describes an exception for small business taxpayers that meet the gross receipts test ($31 million average for 2025, per the Taxpayer Advocate Service). You must still use a method that clearly reflects income. Confirm with a tax professional.

Can I change my inventory method?

Yes, but for US tax it is a change in accounting method that generally requires Form 3115. Under accounting standards, changes also need to be justified and disclosed. Plan it with your accountant.

Sources