Inventory and COGS: LIFO vs FIFO [Video Tutorial] (2024)

Why LIFO vs. FIFO Matters

In our 3-statement “interview question” model, we assumed that COGS = Decrease in Inventory over a specific period.

So the implicit assumption is:

Change in Inventory = Beginning Inventory + Purchases – COGS.

PROBLEM: What do you actually list for COGS? After you buy the Inventory, what should you record for the cost of Inventory once it’s actually sold?

Example: Let’s say you order 100 units during the course of the year, and initially they cost you $10 each… but by the end of the year the cost has increased to $20 each.

When you sell 10 units, do you use 10 * $10 for COGS, or 10 * $20?

That’s the core problem you face when recording COGS and Inventory, and there are 2 methods for handling it:

LIFO (Last In, First Out): You use the cost of the latest items purchased (10 * $20).

FIFO (First In, First Out): You use the cost of the earliest items purchased (10 * $10).

It’s not about which one is “better,” but more about the trade-offs between these two methods — how are Net Income, Inventory, and COGS affected?

Impact on Net Income, Inventory, and COGS

If inventory costs have been INCREASING:

LIFO: Higher COGS, lower Net Income, and a lower ending Inventory balance.

FIFO: Lower COGS, higher Net Income, and a higher ending Inventory balance.

If inventory costs have been DECREASING:

LIFO: Lower COGS, higher Net Income, and a higher ending Inventory balance.

FIFO: Higher COGS, lower Net Income, and a lower ending Inventory balance.

Compromise: Take the average numbers under both methods (many US-based companies do this in real life).

This comes up in real life all the time, so you need to be aware of it — and possibly be ready to make adjustments on the financial statements if companies you’re comparing are using different standards for inventory and COGS.