FIFO, LIFO and Weighted Average Inventory Valuation Example

What are FIFO, LIFO and weighted average cost

FIFO (first in, first out), LIFO (last in, first out) and weighted average cost are the three methods for assigning cost to inventory issues and to the closing balance. When purchase prices change over time, the same physical movements produce a different cost of goods sold (COGS), ending inventory and profit under each method.

The method sets the accounting value, not the physical flow: a plant can consume the newest lot and still value inventory by FIFO. What matters is to choose one method, apply it consistently and trace every issue back to the receipt it came from.

Visual map: three methods, the same receipts and issues

The map values the same set of movements under the three methods and compares COGS, ending inventory and gross profit.

How each method works

• FIFO: issues consume the oldest layers first. Ending inventory holds the most recent purchases and reflects current prices.
• LIFO: issues consume the newest layers first. Ending inventory is valued at old costs.
• Weighted average: every unit is worth the weighted average of the balance. With the moving average, the average is recalculated at each receipt. With the periodic average, one average is calculated for the whole period.

Average cost = value of balance ÷ quantity of balance

COGS = beginning inventory + purchases − ending inventory

Worked example: one month of movements

Fictional example with rising purchase prices. Beginning inventory is 100 units at $10.00. The selling price is $20.00 per unit. Movements:

Total sold: 150 + 180 = 330 units, revenue 330 × 20 = $6,600. Total available: 400 units at $4,800 (1,000 + 2,400 + 1,400). Physical ending inventory: 70 units. Calculation by method, with each issue costed at the time of the sale:

Comparing the results

With the periodic average, the single average is 4,800 ÷ 400 = $12.00: COGS = 330 × 12 = 3,960 and ending inventory = 70 × 12 = 840. Under every method, COGS + ending inventory = 4,800, so the method only splits the same cost between what left and what stayed.

With rising prices, FIFO gives the highest ending inventory (980) and the highest profit (2,780). LIFO gives the lowest inventory (700) and the lowest profit (2,500). The $280 gap between the two is exactly the difference in ending inventory value (980 − 700). The average sits in the middle. With falling prices, the order reverses.

What standards and law allow

• IFRS (IAS 2): allows FIFO and weighted average cost; it does not allow LIFO.
• United States (US GAAP): LIFO is permitted, with its own tax conformity rules.
• Other countries: local tax and accounting rules differ. Confirm the treatment with your accountant.
• Net realizable value: whatever the method, inventory cannot be carried above the net amount you expect to recover by selling it.

Which method to use

The chosen method feeds production cost, inventory turnover (which uses COGS) and margin by product. To decide which items deserve tighter control, combine it with ABC analysis.

How to keep control day to day

1. Record every receipt with date, quantity and full unit cost (price, freight and non-recoverable taxes).
2. Define the method in writing and apply it to all items of the same nature.
3. Post the issue in the system at the time of consumption or sale, linked to MRP and the production order.
4. Reconcile the system balance with the physical count through cycle counting.
5. Review inventory adjustments: recurring discrepancies distort cost under any method.

For replenishment policy and stock levels, see inventory management.

Common mistakes and limitations

• Confusing valuation method with physical flow. Valuing by FIFO does not oblige you to ship the oldest lot, although that is good practice for shelf life.
• Changing method without criteria and without disclosing the change.
• Computing the average with a negative balance: a sale posted before the receipt distorts the moving average cost.
• Ignoring freight and non-recoverable taxes in the receipt cost.
• Mixing moving and periodic averages in the same report.
• Treating the example numbers as a rule. Results depend on each company's price sequence and dates.

Frequently asked questions

What is FIFO?

The method in which the first lot received is the first one issued. COGS uses the oldest costs and ending inventory is valued at the most recent purchases.

What is LIFO?

The method in which the last lot received is the first one issued. COGS uses the most recent costs. IAS 2 does not allow it; US GAAP does.

What is weighted average cost?

The average cost of the units in stock, weighted by quantity: value of balance ÷ quantity of balance. It can be moving (at each receipt) or periodic.

Which method gives the highest profit when prices rise?

FIFO, because it expenses the oldest and lowest costs. In the example, gross profit is $2,780 under FIFO, $2,668 under moving average and $2,500 under LIFO.

What is the difference between moving and periodic average?

Moving recalculates the cost at each receipt and issues at that value. Periodic uses one average at period end. In the example, COGS is $3,932 versus $3,960.

Does the valuation method change total cost?

No. Total cost available is the same ($4,800 in the example). The method only splits it between COGS and ending inventory.

About the author

Vagner Soares

Lean Manufacturing & Behavioral Management Specialist

Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.

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