Editorial · September 16, 2021
Inventory Management: FIFO and LIFO Explained for Owners
Inventory management decides how much profit your books show. It also decides how much tax you owe on goods you buy and resell. This guide explains the two best known ways to count the cost of stock, FIFO and LIFO, in plain words.
Why the way you count stock matters
When you sell goods, you subtract what they cost you to find your profit. That figure is called cost of goods sold. To find it, you need to know what your stock cost at the start of the year, what you bought during the year, and what is left at the end.
The IRS says the value of your inventory is a major factor in figuring your taxable income. It also says you need a method for identifying the items in your inventory and a method for valuing them. Your methods must clearly reflect income, and you must use them the same way from year to year.
Source: IRS Publication 538, Accounting Periods and Methods, revised January 2019, inventories chapter
Specific identification: when you can tell items apart
Some owners can match each item to its own invoice. A car dealer with a few vehicles is a good case. If you can do this, the IRS says to use the specific identification method. You match the real cost to the real item.
Most shops cannot. Think of a hardware store with bins of identical screws bought at different prices over many months. The IRS says that when goods of the same type are mixed together and cannot be tied to specific invoices, you use FIFO or LIFO instead.
Source: IRS Publication 538, identifying cost section.
FIFO: first in, first out
FIFO means first in, first out. It assumes the items you bought or made first are the first ones you sold. The stock left at year end is then matched with the costs of your most recent purchases.
Here is a simple case. You buy 10 jars of honey at $4 each in January. In June you buy 10 more at $6 each. By December you have sold 10 jars. Under FIFO, the 10 jars sold are the $4 jars. Your cost of goods sold is $40, and your closing stock of 10 jars is valued at $60.
Source: IRS Publication 538, FIFO method. The honey example is our own illustration.
LIFO: last in, first out
LIFO means last in, first out. It assumes the items you bought or made last are the first ones you sold. What is left at year end is treated as coming from your oldest stock.
Use the same honey. Under LIFO, the 10 jars sold are the $6 jars. Your cost of goods sold is $60, and your closing stock is valued at $40. The jars and the sales prices are identical. Only the way you count the cost changed.
The IRS notes that the rules for using LIFO are very complex. It points owners to sections 472 through 474 of the Internal Revenue Code for more. Talk to a tax professional before you pick it.
Source: IRS Publication 538, LIFO method and LIFO rules. The honey example is our own illustration.
How the choice changes profit and tax
The IRS explains the difference this way. Each method gives different income results, depending on the trend of prices. When prices are rising, LIFO produces a larger cost of goods sold and a lower closing inventory. FIFO produces a lower cost of goods sold and a higher closing inventory. When prices are falling, the opposite holds.
In our honey case, prices rose from $4 to $6. LIFO gave a cost of goods sold of $60 and FIFO gave $40. A higher cost of goods sold means lower profit on paper, and so lower taxable income that year. FIFO shows more profit and a bigger stock value.
Neither method is better in every case. You also cannot switch back and forth to chase the lower bill. The IRS says your inventory practices must be consistent from year to year, and a change in method of accounting needs the right paperwork, which can include Form 3115.
Source: IRS Publication 538, differences between FIFO and LIFO, and the change in accounting method section.
Smaller businesses and good record habits
The IRS has an exception for small business taxpayers. You qualify if your average yearly gross receipts for the three prior tax years are $25 million or less (indexed for inflation) and you are not a tax shelter. A small business taxpayer can choose not to keep an inventory. It must still use a method of accounting for inventory that clearly reflects income. If you do choose to keep an inventory, you generally must use an accrual method of accounting and value the inventory each year.
Good habits help under any method. Keep invoices that show the date, the supplier and the cost. Count your stock by hand at reasonable intervals. The IRS says that if you use a book or perpetual inventory, the book amount must be adjusted to match the physical count. Remember that casualty or theft losses of stock show up through your opening and closing counts.
Last, ask your tax adviser which method fits your trade and your size. The right answer depends on your goods, your price trends and your records.
Source: IRS Publication 538, exception for small business taxpayers, perpetual or book inventory, and loss of inventory sections.
Sources
Internal Revenue Service, Publication 538, Accounting Periods and Methods (revised January 2019), https://www.irs.gov/publications/p538, as archived by the Internet Archive Wayback Machine on August 20, 2021.