Pick the wrong inventory costing method and you either overstate profit or hand the IRS more than you owe. Kelley Birrell runs the same 300 shirt example through all three methods, average cost, FIFO, and LIFO, and shows your COGS (cost of goods sold) landing at $975, $900, or $1,125 on identical sales. You get the tradeoffs behind each one, the three mistakes sellers make most often, and a scorecard for matching a method to how your business runs.
Inventory & COGS
FIFO, LIFO, and Average Cost: Which method is best?
5 min
Transcript
0:00 Why your costing method matters
What if your inventory method is quietly draining your profits and costing you thousands more in taxes than it should? I'm talking about FIFO, LIFO, and average cost. In this video, I'll show you how each method impacts your bottom line. And at the end, I'll give you a matrix that compares them all so you can decide which one is best for your business.
I'm Kelley with LedgerGurus. We've handled inventory accounting for hundreds of ecommerce brands, and this is one of the most common and costly mistakes that we see. I'll walk you through the top three inventory costing methods, show you when to use each one, and help you avoid common pitfalls that could be hurting your margins.
Whether you update inventory in real time, the perpetual method, or do monthly or yearly counts, the periodic method, these costing methods still apply. Now, what matters is which one fits how your business actually runs and what your financial goals are.
0:48 Average cost
Let's start with average cost. This method takes your total inventory cost and spreads it evenly across all units.
Say you run a print-on-demand shirt business. You buy 200 shirts at $12 each and 100 at $15 each. You don't track which shirt sold first. You just want a clean, simple cost across your inventory. So if you average it, it's $13 per shirt. Sell 75 and your COGS is $975, with $2,925 left in inventory. Average cost works great here.
The pros of this method are it's easy to apply and automate, it's good for consistent pricing, and it minimizes the risk of manipulation. The cons are that it doesn't reflect the actual price changes and it can cause mispricing when costs fluctuate. This method is best for high volume sellers with similar SKUs, like t-shirts, accessories or cosmetics.
1:33 FIFO, first in first out
Next is FIFO, first in first out. This means you sell the oldest inventory first. So imagine that you're selling skincare products. You want to clear out older inventory before it expires, so naturally you're using the oldest batches first. FIFO reflects this flow.
The pros are it matches most natural inventory flow, it often shows higher profits, and it gives a nice clean balance sheet. The cons are it is a higher tax liability at times of inflation and it may overstate net income. This method is best for sellers with perishable goods or short product cycles, like food, beauty, seasonal items, or even apparel with a fast style turnover.
Now, to keep things tidy with our example, let's say that you're running the same shirt business. FIFO says sell the oldest first. So, 75 shirts from the $12 batch is $900 in cost of goods sold, with $3,000 left in inventory. This method makes sense, but just know that when wholesale prices jump, your taxable income may increase more than you expect and may require some tax planning.
2:27 LIFO, last in first out
Then there's LIFO, last in first out. With this method, you sell the newest inventory first. So if you're a large retailer selling consumer electronics or hardware, you're constantly restocking and selling the latest batch. Prices can rise regularly due to inflation and supply chain shifts.
The pros are it reduces your taxable income when the prices rise and it matches recent costs to current sales. The cons are that this method is not allowed outside of the US, it can lead to a lower reported profit, and it can distort inventory value. LIFO is best for large-scale wholesalers or businesses with rising inventory costs and tax sensitivity, like auto parts or supplements. So if you switch to LIFO, you may lower your tax liability, but your books will also show lower profits.
So we're still running that shirt business, and with LIFO, the newest ones go first. So 75 from the $15 batch equals $1,125 in cost of goods sold, with $2,775 left in inventory.
3:20 Switching methods and common mistakes
Quick heads up if you're thinking about changing your inventory costing method. Be aware that it may require IRS approval. We don't handle income taxes here at LedgerGurus, but we can help you understand how this change impacts your accounting and what steps to take with your tax preparer.
Now, let's wrap up with three big mistakes that ecommerce sellers tend to make with inventory costing. Using FIFO by default, even when it doesn't match their business model. Letting average cost run for years without adjusting for price changes. And switching methods without understanding the financial or compliance impact.
3:52 The scorecard
Are you still not sure which method fits your business? Before we wrap up, here's a quick scorecard to help you spot the best method for your business.
FIFO is great for perishable goods or seasonal products. It gives you a clean balance sheet and aligns with how inventory typically flows.
LIFO is a strong fit if your costs are rising and you want to lower your taxable income, but keep in mind that it's US-based only and less intuitive.
Average cost is best for high volume interchangeable products. It's simple to automate and works well when you don't need price precision per unit.
Think about your products, your pricing, and your goals. The right method can tighten your margins and give you a clear financial picture.
4:24 How LedgerGurus can help
And if you're looking to stop guessing and start growing with confidence, we can help. At LedgerGurus, we specialize in inventory consulting and ecommerce accounting built specifically for brands like yours. Whether you're trying to clean up your books, prep for an exit, or just make smarter decisions, our team can help you set up systems that scale.
Book a discovery call today. We'll walk you through how to get control of your inventory, align your costs with your strategy, and build a financial foundation for growth. Like and subscribe for more ecommerce accounting tips. We'll catch you in the next video.