Inventory Costing: FIFO, LIFO and Weighted Average

Introduction

In its fiscal year ended January 2023, Kroger recorded a $626 million last-in, first-out (LIFO) charge, more than three times the $197 million of the year before. The charge did not reflect anything Kroger did differently in its stores. It was the result of an accounting method: Kroger values most of its inventory on a LIFO basis, so when grocery costs rose sharply, the most recent and most expensive purchases flowed into cost of goods sold, and the larger charge accounted for about half of the fall in its gross margin from 22.01% to 21.43%. The following year, as inflation eased, the charge fell to $113 million and the margin recovered.

Inventory costing methods exist because a company holding thousands of identical units bought at different prices has to decide which costs to attach to the units it sells and which to the units still on its shelves. The choice does not change what was sold, what was paid or what was received. It changes cost of goods sold, gross profit, taxable income, the inventory balance and, through taxes, cash. For bankers comparing retailers, distributors, refiners and manufacturers, the method is one of the first things to check before reading any margin.

A distributor that buys 100 units at $10, then 100 at $12 and 100 at $14, and sells 200 of them, cannot usually tell which physical units left the warehouse. Even if it could, the accounting does not need to track physical flow. Accounting Standards Codification (ASC) 330 lets companies choose a cost flow assumption, a convention for which costs are treated as sold first, applied consistently from period to period. How inventory reaches cost of goods sold on the statements is traced in inventory transactions on the three statements.

Cost flow assumption

The convention a company uses to assign the cost of interchangeable inventory units to cost of goods sold and to ending inventory, such as first-in, first-out, last-in, first-out or weighted average. It need not match the physical flow of goods but must be applied consistently.

US generally accepted accounting principles (US GAAP) permit four approaches, each suited to different businesses:

The retail inventory method, used by many department stores and supermarkets, is not a separate cost flow assumption but a way of estimating cost from retail prices, combined with FIFO, LIFO or average cost.

The arithmetic shows how far the methods can diverge. Suppose the distributor starts the year with 100 units bought at $10, buys 100 at $12 and then 100 at $14, and sells 200 units at $20 each. Its goods available for sale cost $3,600 in total; the methods differ only in how that cost is split between the 200 units sold and the 100 units left:

With a 25% tax rate, the income statements compare as follows:

With rising prices, LIFO produces the highest cost of goods sold, the lowest profit and the lowest inventory; FIFO the reverse; weighted average sits between them. The difference between FIFO and LIFO here is $400 of cost of goods sold. On the statements, choosing LIFO instead of FIFO reduces pre-tax income by $400, tax by $100 and net income by $300; because the tax is paid in cash, operating cash flow, built up in the indirect method reconciliation, is $100 higher; and on the balance sheet inventory is $400 lower while cash is $100 higher, so total assets fall by $300, matched by $300 less retained earnings. The cash advantage is the only economic difference between the two; everything else is presentation. The mechanics of gross profit itself are covered in cost of goods sold and gross profit.

Periodic and Perpetual Systems

The example applies each method to the whole year at once, a periodic calculation. Companies with perpetual systems, which update inventory with every sale, apply the method transaction by transaction, and for LIFO and weighted average that can give different answers from the periodic calculation, because the newest costs or the average cost at the moment of each sale may differ from those at year end. FIFO gives the same result either way, since the oldest costs are the oldest costs whenever they are counted. Large LIFO users typically calculate LIFO for the books at year end, often using indexes rather than individual items, and estimate it during the year.

The methods produce the same results only when prices are stable. When costs rise, LIFO matches the newest, highest costs against current revenue, so its gross margin reflects current replacement costs and excludes the gains from holding inventory bought earlier at lower prices. FIFO includes those inventory holding gains in profit, so in a period of inflation it reports higher margins that partly reflect price increases rather than operating performance. When costs fall, the pattern reverses: LIFO produces lower cost of goods sold and higher profit than FIFO. Run the same example with purchases at $14, then $12, then $10: FIFO now expenses the expensive early units, giving cost of goods sold of $2,600 and ending inventory of $1,000, while LIFO expenses the cheap recent units, giving $2,200 and $1,400. Weighted average is unchanged at $2,400, because the average of the three prices is still $12. In deflation, then, LIFO reports the higher profit and pays more tax, which is why companies whose costs tend to fall, such as many electronics manufacturers, rarely choose it.

Inventory holding gain

The increase in the value of inventory between purchase and sale caused by rising input prices. Under FIFO it is included in reported gross profit when the goods are sold; under LIFO it largely stays out of profit and accumulates as the difference between inventory's historical cost and its current cost.

LIFO's main attraction in the United States is tax. In a period of rising prices, higher cost of goods sold means lower taxable income and lower cash taxes, year after year, as long as inventory levels are maintained. The price of that benefit is the LIFO conformity rule: section 472(c) of the Internal Revenue Code allows a company to use LIFO for tax only if it also uses LIFO in its financial reports to shareholders and creditors, as Internal Revenue Service (IRS) rulings applying the conformity requirement set out. A company cannot report FIFO profits to investors while paying taxes on LIFO profits, so LIFO users accept lower reported earnings for the cash benefit.

The Tax Benefit Over Time

The benefit compounds as long as prices rise and inventory is maintained. Each year's LIFO charge reduces taxable income, and the cumulative difference between LIFO and FIFO inventory, the LIFO reserve, multiplied by the tax rate approximates the taxes deferred to date. At Kroger, a reserve of about $2.2 billion at an effective tax rate in the low 20s implies roughly $0.5 billion of cumulative taxes deferred. The deferral is not permanent: if inventory is run down or the company switches to FIFO, the old, low costs flow into cost of goods sold, taxable income rises and the tax comes due. For a business that keeps growing its inventory in an inflationary economy, however, the deferral can last indefinitely, which is why LIFO users have fought hard against repeated repeal proposals, from presidential budgets to the 2013 and 2014 tax reform drafts of both congressional tax-writing committees.

LIFO Layers and Dollar-Value LIFO

LIFO inventory is built up in layers. The base layer is the inventory held when the company adopted LIFO, carried at that year's costs; each later year in which inventory grows adds a new layer at that year's costs. Because the newest costs are always expensed first, the oldest layers can remain on the balance sheet for decades at prices far below current costs. Tracking layers item by item would be impractical for a retailer with tens of thousands of products, so most large users apply dollar-value LIFO, grouping inventory into pools and measuring changes in each pool's size with price indexes rather than unit counts. Kroger, for example, uses a link-chain, dollar-value LIFO method, which measures each year's price change and chains the yearly indexes together into a cumulative one. Pools make LIFO practical, and they also make it harder for outsiders to estimate the charge before the company reports it. The cumulative effect of all the layers, the gap between LIFO inventory and its current cost, is disclosed as the LIFO reserve, explained in the LIFO reserve and LIFO liquidations.

Weighted Average in Practice

Weighted average cost is the default for many manufacturers, chemical and commodity processors and companies running modern enterprise systems, which recalculate a moving average cost for each item after every receipt. It smooths price changes rather than passing them into cost of goods sold at once, as LIFO does, or only after the older stock has been sold, as FIFO does: a spike in input prices raises average cost gradually as new purchases mix with existing stock. Its results usually sit between FIFO and LIFO, closer to FIFO when inventory turns quickly and closer to the older costs when stock is held for long periods. For analysis, weighted average reporters can usually be compared with FIFO reporters without adjustment in stable markets, but in years of sharp price moves the lag in average cost can delay the margin effect by a quarter or two.

Who Uses Which Method

The result is a recognizable pattern across industries. LIFO is used mainly by US companies with large, slowly turning inventories of goods whose costs tend to rise: supermarkets and drug stores, oil refiners, chemical producers, steel and industrial distributors, and some auto dealers. Companies with falling costs, such as many technology hardware makers, rapid inventory turnover, or international operations reporting under other frameworks generally use FIFO or weighted average, and many companies use different methods for different parts of their inventory. Kroger, for example, valued about 89% of its inventories on LIFO at the end of fiscal 2022, with substantially all of its fuel inventories on FIFO.

Kroger reports the effect of LIFO as a separate LIFO charge within its merchandise costs, the amount by which LIFO cost of goods sold exceeds what FIFO would have produced. Its fiscal 2022 annual report and the following year's filing show the charge tracking inflation:

The pattern matches the theory. As grocery inflation peaked, the LIFO charge more than tripled and the reported gross margin fell by more than half a percentage point, about half of it from the larger charge alone; as inflation eased, the charge shrank and the margin rose, and Kroger's fiscal 2023 annual report listed the lower LIFO charge first among the reasons for the improvement. Because the charge depends on inflation rather than operations, Kroger also reports a FIFO gross margin, excluding the LIFO charge, and adds back the LIFO charge in its measure of return on invested capital, so that investors can see underlying performance. At the end of fiscal 2022, replacement cost exceeded the carrying amount of Kroger's inventory by about $2.2 billion, up from $1.6 billion a year earlier; the $626 million increase is exactly the year's LIFO charge.

The method also decides which write-down test applies. Inventory measured on FIFO or weighted average is carried at the lower of cost and net realizable value, the expected selling price less costs to complete and sell. Inventory measured on LIFO or the retail inventory method remains under the older lower of cost or market test, which uses replacement cost bounded by a ceiling and a floor. Because LIFO inventory is carried at old, low costs, it is rarely written down for price declines; FIFO inventory, carried near current cost, is more exposed. The tests are covered in inventory write-downs.

Changing Methods

A company may change its inventory method only if the new method is preferable, and the change is generally applied retrospectively, restating prior periods as if the new method had always been used. A switch from LIFO to FIFO is the usual direction, often after a company expands abroad or concludes that the tax benefit no longer justifies lower reported earnings; the switch raises reported inventory and retained earnings and, for tax, generally triggers recapture of the deferred LIFO benefit over several years. The treatment of such changes is covered in restatements and accounting changes.

Bankers adjust for inventory methods whenever companies using different ones are compared. The adjustments follow directly from the example:

The FIFO view is not automatically the better one. It removes the effect of inflation on cost of goods sold, which helps when comparing Kroger with a FIFO competitor, but it also adds back inventory holding gains that are not a repeatable source of profit. For valuation, many bankers use FIFO margins to compare operations and LIFO figures to estimate cash taxes, and they note which basis each peer uses in the comparison table.

The broader working capital ratios affected by inventory valuation, such as days inventory outstanding, are covered in DSO, DIO and DPO; a LIFO user's understated inventory makes its days inventory look shorter than a FIFO peer's for the same physical stock. Whatever the method, the cash spent on inventory and the units sold are the same; the method only decides when rising or falling prices reach the income statement, and how much tax is paid along the way.