Inventory: FIFO, LIFO and write-downs
By SuperdayReps · Michigan Ross Undergrad | Wharton MBA · ex-Citi | ex-Greenhill · Former Head Mentor at a Leading IB Prep Service
8 min read · updated October 14, 2026
A hardware store buys the same hammer three times in a year, and each time it costs more. Then it sells a pile of hammers. What did those hammers cost?
You might think there is one right answer. There is not. The hammers are identical, so accounting lets the company pick an assumption about which ones it sold, and that assumption changes reported profit, the tax bill and the balance sheet. It is a small question with a surprisingly large footprint, which is why interviewers like it.
Why the method matters at all
Inventory sits on the balance sheet at cost. When a unit is sold, its cost moves to the income statement as cost of goods sold. If every unit cost the same, the method would not matter. Once costs change over time, the company has to decide which costs leave with the sale and which stay behind.
Three methods cover nearly everything you will see:
- FIFO, first in, first out. The oldest units are treated as sold first.
- LIFO, last in, first out. The newest units are treated as sold first.
- Weighted average. Every unit carries the average cost of everything available.
None of them has to match how the goods physically move. A grocery store sells its oldest milk first in real life and can still use LIFO on its books. The method is a cost flow assumption, not a description of the warehouse.
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Frequently asked
- What is the difference between FIFO and LIFO?
- FIFO, first in first out, assumes the oldest inventory is sold first, so cost of goods sold uses older costs and ending inventory reflects recent costs. LIFO, last in first out, assumes the newest inventory is sold first, so cost of goods sold uses the most recent costs and the old costs stay on the balance sheet. Neither has to match how the goods physically move.
- In a period of rising costs, which method gives higher net income?
- FIFO. It matches revenue against the older, cheaper costs, so cost of goods sold is lower and profit is higher. LIFO matches revenue against the newest, more expensive costs, so cost of goods sold is higher, profit and taxes are lower, and cash flow is actually higher because of the tax saved. The balance sheet flips: FIFO shows a higher, more current inventory value.
- Why do companies use LIFO?
- To save tax when costs are rising. Higher cost of goods sold means lower taxable income. In the US the LIFO conformity rule says a company using LIFO for taxes must also use it in its financial statements, so it reports lower profit to get the tax benefit. LIFO is not allowed under IFRS, so it is essentially a US practice.
- What happens when inventory is written down by $100?
- At a 40% tax rate, the write-down is an expense, so pre-tax income falls $100, taxes fall $40 and net income falls $60. On the cash flow statement you add back the $100 because it is non-cash, so cash is up $40 from the tax saving. On the balance sheet, cash is up $40 and inventory is down $100, so assets fall $60, matching a $60 drop in retained earnings.
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