The owner of a hardware store is picture in the backroom of his store. He is counting his inventory of items and making a note of it using a clipboard.
FIFO and LIFO are different methods of accounting for the movement of inventory and its applicable costs. There are some rules and caveats to be aware of with each method. — Getty Images/andresr

FIFO and LIFO are two accounting methods used to assess inventory costs. FIFO stands for "first in, first out." LIFO is an acronym for "last in, first out."

FIFO and LIFO determine how you value your company's inventory and calculate your cost of goods sold (COGS). They differ in how they assume inventory flows in and out of your company. Here's how to determine which approach is right for your business and how to use FIFO and LIFO compliantly.

How does FIFO work?

The first in, first out method assumes that the oldest items in your inventory are sold first. The COGS calculation therefore uses the cost of your oldest inventory multiplied by the total amount sold to come up with a number.

FIFO is generally the most common approach to inventory accounting. "Most businesses offload oldest products first anyway – since older inventory might become obsolete and lose value," wrote FreshBooks. "As such, FIFO is just following that natural flow of inventory, meaning less chance of mistakes when it comes to bookkeeping."

How is LIFO calculated?

Last in, first out uses the costs of the most recent inventory as the baseline for calculating COGS. It assumes that the newest inventory is sold first.

Some business owners use the LIFO approach because inventory costs usually rise over time, eating into the company's profit margins. LIFO accounting allows the company to pay lower taxes as a result. However, to get an accurate read on the company's profits, LIFO isn't the ideal option.

"Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete," wrote Investopedia. "As a result, LIFO doesn't provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today's prices."

[Read more: What Is the Difference Between Accounting and Financial Planning?]

[The] LIFO approach tends to understate the value of the closing stock and overstate COGS, which is not accepted by most taxation authorities. If a company uses the LIFO method, it will need to prepare separate calculations, which calls for additional resources.

The Corporate Finance Institute

Should your business use LIFO or FIFO?

Most businesses benefit from using the FIFO calculation. It's easy to use, accepted, and trusted by investors, lenders, and the IRS, and it follows the natural physical flow of inventory. FIFO is the right choice, especially for businesses that deal in perishable goods, such as restaurants.

LIFO is only permitted as one of the Generally Accepted Accounting Principles (GAAP) in the United States. International companies can't use LIFO as an accounting practice.

"[The] LIFO approach tends to understate the value of the closing stock and overstate COGS, which is not accepted by most taxation authorities. If a company uses the LIFO method, it will need to prepare separate calculations, which calls for additional resources,” wrote the Corporate Finance Institute.

LIFO is favored by companies that are seeking to attract investors since lower taxable income from LIFO translates to a lower tax liability. This can improve a company's cash flow, a key metric that investors will look at when determining whether to commit funding.

LIFO is also the preferred option during periods of inflation. The COGS is higher since LIFO assumes the most recent, presumably more expensive inventory is sold first. This results in a lower taxable income for the company.

A third option: Average cost

The average inventory method offers a middle ground between LIFO and FIFO. In this approach, take the weighted average of all units available for sale during the accounting period. Then, use that average cost to determine the value of COGS and ending inventory.

If FIFO results in the highest net income and LIFO is the lowest, the average inventory method lands somewhere between these two figures. However, this method is more time-consuming to calculate, and during inflation, the average cost method might not accurately reflect the current replacement cost of inventory. This can impact the valuation of ending inventory and COGS.

Ultimately, the decision between LIFO and FIFO depends on a company's specific circumstances and its financial goals. It's always best to consult with a tax adviser or accountant to determine the most suitable method.

[Read more: Accounts Payable vs. Accounts Receivable: What's the Difference?]

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