What is FIFO?

FIFO is an acronym for first in, first out. It is a cost layering concept under which the first goods purchased are assumed to be the first goods sold. This approach is especially common when goods are expected to age over time, so it makes sense to eliminate the oldest items from stock first.

What is LIFO?

LIFO is a contraction of the term "last in, first out," and means that the goods last added to inventory are assumed to be the first goods removed from inventory for sale. This approach is most commonly used in an inflationary environment, where the cost of the newest items tends to be higher than the cost of older items. By shifting the cost of newer items directly into the cost of goods sold when goods are sold, a business can increase its reported cost of goods sold, and therefore lower its reported income.

Comparing FIFO and LIFO

Why use one method over the other? Here are some considerations that take into account the fields of accounting, materials flow, and financial analysis:

Issue	FIFO Method	LIFO Method
Materials flow	In most businesses, the actual flow of materials follows FIFO, which makes this a logical choice.	There are few businesses where the oldest items are kept in stock whiler newer items are sold first.
Inflation	If costs are increasing, the first items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.	If costs are increasing, the last items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.
Deflation	If costs are decreasing, the first items sold are the most expensive, so your cost of goods sold increases, you report fewer profits, and therefore pay a smaller amount of income taxes in the near term.	If costs are decreasing, the last items sold are the least expensive, so your cost of goods sold decreases, you report more profits, and therefore pay a larger amount of income taxes in the near term.
Financial reporting	There are no GAAP or IFRS restrictions on the use of FIFO in reporting financial results.	IFRS does not all the use of the LIFO method at all. The IRS allows the use of LIFO, but if you use it for any subsidiary, you must also use it for all parts of the reporting entity.
Record keeping	There are usually fewer inventory layers to track in a FIFO system, since the oldest layers are continually used up. This reduces record keeping.	There are usually more inventory layers to track in a LIFO system, since the oldest layers can potentially remain in the system for years. This increases record keeping.
Reporting fluctuations	Since there are few inventory layers, and those layers reflect recent pricing, there are rarely any unusual spikes or drops in the cost of goods sold that are caused by accessing old inventory layers.	There may be many inventory layers, some with costs from a number of years ago. If one of these layers is accessed, it can result in a dramatic increase or decrease in the reported amount of cost of goods sold.

In essence, the primary reason for using LIFO is to defer the payment of income taxes in an inflationary environment. Despite this, LIFO accounting is not recommended, for several reasons. First, it is not allowed under IFRS, and a large part of the world uses the IFRS framework. Second, the number of layers to track can be substantially larger than would be the case under FIFO. Third, if old layers are accessed, costs may be charged to expense that vary substantially from current costs.