FIFO or LIFO: which inventory method should a seller use?

When identical units are bought at different prices and mixed together on a shelf, in a 3PL or at an Amazon fulfillment center, you cannot tell which unit went out in which order. An inventory method is the rule that decides which cost goes with each sale. The IRS describes the two named methods this way. FIFO (first-in, first-out) assumes the items you bought first are the first items you sold, so the stock left at year end carries the costs of your most recent purchases.^[1] LIFO (last-in, first-out) assumes the items you bought last are the first sold, so closing stock carries the oldest costs.^[1]

The example above follows one product in the demo store: 100 camp stoves on hand at 22.00 each, then the 400-stove shipment that cost 24.00 each landed, after the supplier raised its price. 300 stoves sold. The same 300 sales cost 7,000.00 under FIFO and 7,200.00 under LIFO, and the difference, 200.00, is exactly the 100 older stoves times the 2.00 price rise.

Four methods cover what online sellers meet in practice. Here is the same month of camp stoves under each.

Average cost spreads the total cost of the stock across every unit. The demo store's books use average landed cost, because units from different shipments are mixed in the same bins and the same fulfillment centers. Specific identification matches the actual cost to the actual item; the IRS says to use it when you can identify and match the actual cost to the items, and to use FIFO or LIFO when goods are intermingled and cannot be identified with specific invoices.^[1] For identical units mixed across shipments, that points to FIFO or LIFO; specific identification fits one-of-a-kind or serial-numbered goods. Publication 538 names specific identification, FIFO and LIFO as the ways to identify cost;^[1] whether average cost suits your return is a question for your tax preparer.

The IRS puts the effect plainly: when prices are rising, LIFO produces a larger cost of goods sold and a lower closing inventory, FIFO a lower cost of goods sold and a higher closing inventory, and when prices fall the opposite holds.^[1] On the camp stoves, sold at 45.00 each:

No method changes what the stoves cost in total. All 11,800.00 reaches cost of goods sold once every stove has sold; the method only decides which month or year carries which part. That is why the choice matters most when prices move steadily in one direction, and why a method switched halfway through a year makes months impossible to compare. Pub 538 also requires your inventory practices to be consistent from year to year.^[1] Whichever method is used, each lot's cost should be its landed cost, freight and duty included, or every method gives the wrong cost of goods sold and the wrong value for inventory on the balance sheet.

LIFO is not a setting you switch on. It is adopted by filing Form 970, Application To Use LIFO Inventory Method, or a statement with the same information, with your timely filed tax return for the first year you use it.^[1][2] Pub 538 calls the LIFO rules very complex and points to sections 472 through 474 of the Internal Revenue Code.^[1] Three things on the form itself are worth knowing before your tax preparer raises it:

• It is hard to undo. Once adopted, LIFO is irrevocable unless the IRS allows you to change to another method.^[3]
• Your other reports come into it. Form 970 asks whether you issued credit statements or reports to shareholders, partners or other proprietors covering the year, and if so, which inventory method those statements used to determine income.^[3] Statements you give a lender or your co-owners are part of the picture.
• There is a simplified route for small businesses. An eligible small business can elect a simplified dollar-value LIFO method based on government price indexes.^[3]

Changing any method of accounting for inventory, LIFO or not, means filing Form 3115.^[1] Whether LIFO is worth it for your return is a decision for your tax preparer. What the books can do is keep a lot-by-lot cost record, so that decision is made with real numbers.

1. 01

   Lots without landed cost

   Each shipment enters inventory at the supplier price, so every method values stock too low and sales too profitable.

2. 02

   Two methods in two systems

   The inventory app costs sales one way and the ledger another, so stock in the books never agrees with stock in the app.

3. 03

   Fulfillment-center stock left out of the lots

   Units at Amazon or a 3PL are not counted, so the oldest lots look sold when they are still on hand.

4. 04

   Returns re-entered at today's cost

   A restocked return goes back in at the latest price instead of the cost it left at, and the lot record drifts a little every month.

If you cannot say which method your books use, or your stock value differs from your inventory app, the method is the smaller problem; the lot record is the larger one. Our e-commerce inventory accounting keeps landed cost per lot, every stock location counted, one method used consistently in the books, and cost of goods sold that ties to what you actually sold, so your tax preparer has a clean record whichever method goes on the return.