Inventory Methods: FIFO, LIFO, and Weighted Average - Complete
Study Guide
What Are Inventory Costing Methods?
Inventory costing methods determine which costs get assigned to:
Cost of Goods Sold (COGS) on the Income Statement
Ending Inventory on the Balance Sheet
When a company buys inventory at different prices throughout the year, it needs a system to
decide which costs to use when items are sold.
Real-World Example
Imagine a electronics store that sells smartphones:
January: Bought 100 phones at $400 each
June: Bought 100 phones at $450 each
December: Bought 100 phones at $500 each
If they sell 150 phones during the year, which costs should go to COGS? The $400 phones? The
$500 phones? A mix? That's what inventory methods determine!
The Three Main Methods
Method What It Assumes Cost Flow Best Used When
First items bought are first Oldest costs → Prices are rising, want higher
FIFO
items sold COGS profits
Last items bought are first Newest costs → Prices are rising, want lower
LIFO
items sold COGS taxes
Weighted All items cost the average Average cost → Prices fluctuate, want
Average price COGS smoothed results
, Detailed Method Explanations
1. FIFO (First-In, First-Out)
Concept: The oldest inventory costs are assigned to COGS first, newest costs stay in ending
inventory.
Physical Flow Analogy: Like a grocery store - older milk goes to customers first, newer milk stays
on shelves.
FIFO Characteristics Table
Aspect Impact
When Prices Rise Lower COGS, Higher profits, Higher taxes
When Prices Fall Higher COGS, Lower profits, Lower taxes
Balance Sheet Ending inventory reflects current/recent costs
Income Statement COGS may not reflect current replacement costs
Cash Flow Higher profits = Higher taxes = Less cash
2. LIFO (Last-In, First-Out)
Concept: The newest inventory costs are assigned to COGS first, oldest costs stay in ending
inventory.
Physical Flow Analogy: Like a stack of papers - you take from the top (newest) first, bottom
papers (oldest) stay.
Study Guide
What Are Inventory Costing Methods?
Inventory costing methods determine which costs get assigned to:
Cost of Goods Sold (COGS) on the Income Statement
Ending Inventory on the Balance Sheet
When a company buys inventory at different prices throughout the year, it needs a system to
decide which costs to use when items are sold.
Real-World Example
Imagine a electronics store that sells smartphones:
January: Bought 100 phones at $400 each
June: Bought 100 phones at $450 each
December: Bought 100 phones at $500 each
If they sell 150 phones during the year, which costs should go to COGS? The $400 phones? The
$500 phones? A mix? That's what inventory methods determine!
The Three Main Methods
Method What It Assumes Cost Flow Best Used When
First items bought are first Oldest costs → Prices are rising, want higher
FIFO
items sold COGS profits
Last items bought are first Newest costs → Prices are rising, want lower
LIFO
items sold COGS taxes
Weighted All items cost the average Average cost → Prices fluctuate, want
Average price COGS smoothed results
, Detailed Method Explanations
1. FIFO (First-In, First-Out)
Concept: The oldest inventory costs are assigned to COGS first, newest costs stay in ending
inventory.
Physical Flow Analogy: Like a grocery store - older milk goes to customers first, newer milk stays
on shelves.
FIFO Characteristics Table
Aspect Impact
When Prices Rise Lower COGS, Higher profits, Higher taxes
When Prices Fall Higher COGS, Lower profits, Lower taxes
Balance Sheet Ending inventory reflects current/recent costs
Income Statement COGS may not reflect current replacement costs
Cash Flow Higher profits = Higher taxes = Less cash
2. LIFO (Last-In, First-Out)
Concept: The newest inventory costs are assigned to COGS first, oldest costs stay in ending
inventory.
Physical Flow Analogy: Like a stack of papers - you take from the top (newest) first, bottom
papers (oldest) stay.
