How to Calculate FIFO, LIFO, and Average Cost

Businesses frequently manage various goods, from raw materials to finished products, as part of their operations. To accurately reflect financial performance, companies must assign a cost to the items they sell and to the items that remain unsold in their inventory at the end of an accounting period. This process ensures that both the cost of goods sold, which impacts profit, and the value of inventory on the balance sheet are correctly reported. Different accounting methods are available for this purpose, providing various approaches to how these costs are allocated. Among the most widely used methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the Weighted-Average Cost method.

These inventory costing methods provide frameworks for tracking the flow of costs through a business’s inventory system. Each method operates under a specific assumption about which goods are sold first, directly influencing the financial statements. Understanding these approaches is fundamental for anyone looking to interpret a company’s financial health or manage their own business inventory effectively. The choice of method can significantly alter reported profits and inventory values, making it an important decision for financial reporting.

Overview of Inventory Costing Methods

The First-In, First-Out (FIFO) method operates on the assumption that the first units of inventory purchased or produced are the first ones sold to customers. This means that the costs associated with the oldest inventory items are expensed as Cost of Goods Sold (COGS) before the costs of newer items. Consequently, the inventory remaining at the end of a period is assumed to consist of the most recently acquired goods.

Conversely, the Last-In, First-Out (LIFO) method assumes that the latest units of inventory purchased are the first ones sold. Under this approach, the costs of the most recent inventory acquisitions are recognized as COGS before the costs of older items. This assumption leads to the ending inventory being valued based on the costs of the earliest units purchased.

The Weighted-Average Cost method calculates an average cost for all goods available for sale during a period. This approach combines the costs of all inventory units, regardless of their purchase date, and divides it by the total number of units. The resulting average cost per unit is then applied to both the goods sold and the goods remaining in inventory. This method provides a smoothed cost allocation, differing from the sequential assumptions of FIFO and LIFO.

Example Data for Calculations

For the following examples, assume a business starts with no inventory and makes three purchases:
100 units at $10 each ($1,000)
150 units at $12 each ($1,800)
50 units at $13 each ($650)

This results in a total of 300 units available for sale at a total cost of $3,450. Assume 220 units were sold during the period for all calculations.

Calculating First-In, First-Out (FIFO)

Calculating inventory costs using the FIFO method involves tracking each inventory purchase and its unit cost. When goods are sold, FIFO assumes the first units acquired are the first ones sold. This matches older costs against current revenues.

To determine Cost of Goods Sold (COGS) under FIFO, costs are allocated from the earliest purchased units until the total units sold are accounted for. For example, if 220 units were sold and the first purchase was 100 units at $10, those 100 units are expensed first. If more units are needed, the next oldest purchase is used. This aligns with the natural flow of many businesses, where older stock is sold first.

Ending inventory under FIFO is determined by the costs of the most recently purchased units that remain unsold. If 80 units remain, they are assigned the costs of the latest purchases. This often values ending inventory closer to current market prices.

Using the example data, if 220 units were sold, COGS using FIFO is calculated: The first 100 units are from the first purchase ($10 each, totaling $1,000). The remaining 120 units come from the second purchase ($12 each, totaling $1,440). Total COGS is $1,000 + $1,440 = $2,440.

Ending inventory consists of remaining units from the latest purchases. 30 units remain from the second purchase (150 – 120 sold), and all 50 units from the third purchase remain. The 80 units in ending inventory are 30 units from the second purchase ($12 each, $360) and 50 units from the third purchase ($13 each, $650). Total ending inventory value is $360 + $650 = $1,010.

Calculating Last-In, First-Out (LIFO)

Calculating inventory costs using the LIFO method involves tracking each inventory purchase and its unit cost. LIFO assumes the most recently acquired units are the first ones sold. This method assigns the newest costs to goods sold.

To determine COGS under LIFO, costs are assigned from the latest purchased units first, working backward until total units sold are accounted for. For example, if 220 units were sold and the most recent purchase was 50 units at $13, those 50 units are expensed first. Additional units come from the next most recent purchase. This approach means COGS reflects more current costs.

Ending inventory under LIFO is determined by the costs of the earliest purchased units that remain unsold. If 80 units remain, they are assigned the costs of the oldest purchases. This often values ending inventory at older, potentially lower, costs.

Using the example data, if 220 units were sold, COGS using LIFO is calculated: The first 50 units are from the most recent (third) purchase ($13 each, $650). The next 150 units come from the second purchase ($12 each, $1,800). The remaining 20 units come from the first purchase ($10 each, $200). Total COGS is $650 + $1,800 + $200 = $2,650.

Ending inventory consists of remaining units from the earliest purchases. 80 units remain from the first purchase (100 – 20 sold). All units from the second and third purchases were sold. The 80 units in ending inventory are from the first purchase ($10 each). Total ending inventory value is 80 units $10/unit = $800.

Calculating Weighted-Average Cost

Calculating inventory costs using the Weighted-Average Cost method determines a single average cost per unit for all goods available for sale. This approach smooths cost fluctuations by not adhering to a specific flow assumption like FIFO or LIFO. It is useful for businesses with large volumes of identical items where individual unit identification is impractical.

To calculate the weighted-average cost per unit, divide the total cost of all goods available for sale by the total units available. This includes beginning inventory plus all purchases. Once determined, this average cost is applied uniformly to both units sold and units remaining in inventory. This simplifies costing, as every unit is treated as having the same cost.

After determining the average cost per unit, COGS is calculated by multiplying the units sold by this weighted-average cost. Ending inventory value is found by multiplying remaining units by the same weighted-average cost. This consistency ensures both financial statement figures derive from the same cost basis.

Using the example data, to find the weighted-average cost per unit, divide the total cost of goods available for sale by total units available. Here, $3,450 divided by 300 units equals a weighted-average cost of $11.50 per unit. This average cost is used for both COGS and ending inventory calculations.

If 220 units were sold, COGS is calculated by multiplying 220 units by the weighted-average cost of $11.50 per unit. This results in a COGS of $2,530. This calculation reflects the overall average cost of inventory.

Ending inventory consists of the remaining 80 units (300 total units available – 220 units sold). To determine its value, multiply the 80 units by the weighted-average cost of $11.50 per unit. This yields an ending inventory value of $920. The weighted-average method provides a stable cost figure for inventory transactions.