It is the third week of January and your accountant asks one question: “What was your ending inventory on December 31?” You open the spreadsheet, stare at the numbers, and realize you have no idea which costs belong in that figure. If you sell physical products, that moment is more common than you would think, and the answer directly changes your profit and your tax bill.
Inventory is usually the largest asset on a product business’s balance sheet, and how you value it determines your cost of goods sold (COGS). This guide explains the three main inventory costing methods, FIFO, LIFO and weighted average, in plain English, with a worked example you can follow without an accounting degree.
Why Inventory Accounting Matters for Your Profit and Taxes
Every unit you sell moves from the balance sheet (as inventory) to the income statement (as COGS). The formula is simple:
Beginning inventory + purchases − ending inventory = cost of goods sold.
If ending inventory is overstated, COGS is understated and your profit looks better than it really is, which means you pay tax on income you did not earn. If it is understated, the reverse happens. The IRS expects businesses that produce, purchase or sell merchandise to account for inventory (see IRS Publication 538, Accounting Periods and Methods), so getting this right is not optional.
The Three Inventory Costing Methods
Prices change. If you bought the same product three times at three different prices, which cost do you assign to the unit you just sold? That is the question these methods answer. Here is the example we will use throughout:
- Jan 1: bought 100 units at $10 each ($1,000)
- Feb 1: bought 100 units at $12 each ($1,200)
- Mar 1: bought 100 units at $14 each ($1,400)
- By March 31 you have sold 150 units
FIFO (First-In, First-Out)
FIFO assumes the oldest units are sold first. Your 150 sales are the 100 January units ($1,000) plus 50 February units ($600), so COGS is $1,600. Ending inventory is the newest stock: 50 units at $12 plus 100 at $14 = $2,000.
FIFO matches how most physical businesses actually move product (especially perishables), it is accepted for both GAAP and tax purposes, and it is the default in QuickBooks Online Plus and Advanced inventory tracking. In a period of rising prices it produces higher reported profit.
LIFO (Last-In, First-Out)
LIFO assumes the newest units are sold first. Your 150 sales are 100 March units ($1,400) plus 50 February units ($600), so COGS is $2,000 and ending inventory is $1,600. When prices rise, LIFO lowers taxable profit.
There are catches. LIFO is permitted under U.S. GAAP but not under IFRS, and if you use it for taxes the IRS conformity rule generally requires you to use it for financial reporting too. You elect it by filing Form 970, and it is far more complex to maintain. Most small businesses do not use it, and you should talk to a CPA before choosing it.
Weighted Average Cost
This method blends all costs. Total cost is $3,600 for 300 units, so the average is $12 per unit. COGS for 150 units is $1,800 and ending inventory (150 units) is $1,800. It smooths out price swings and is simple to apply, which makes it popular for products that are interchangeable, like bulk materials.
FIFO vs LIFO vs Weighted Average: Side-by-Side
- FIFO: COGS $1,600, ending inventory $2,000, highest profit in rising markets
- LIFO: COGS $2,000, ending inventory $1,600, lowest profit and lowest tax in rising markets
- Weighted average: COGS $1,800, ending inventory $1,800, a middle path
Notice that total cost ($3,600) is the same in every case. The methods only change when costs hit your income statement. For most small businesses, we recommend FIFO or weighted average: they are accepted, easy to defend in an audit, and supported by the major software platforms.
Perpetual vs Periodic Inventory Tracking
Separate from the costing method is how often you update your records:
- Perpetual: inventory and COGS update with every sale, usually through a point-of-sale or ecommerce integration. This is what QuickBooks Online and Xero (with an add-on such as inventory apps) support, and it gives you real-time visibility.
- Periodic: you count stock at period end and calculate COGS using the formula above. It is cheaper but you are flying blind between counts.
A Practical Inventory Accounting Checklist
- Pick one costing method and apply it consistently. Changing methods generally requires IRS approval (Form 3115).
- Record the full landed cost: purchase price plus freight-in, duties and handling to get goods ready for sale.
- Do a physical count at least once a year, and quarterly or monthly if you can.
- Reconcile your count to the general ledger and book adjustments for shrinkage, damage and theft.
- Write down obsolete or damaged stock to its net realizable value.
- Keep supplier invoices, count sheets and adjustment memos for at least three years (longer is safer).
- Make sure inventory purchases are coded to an asset account, not expensed straight away.
Common Inventory Accounting Mistakes
- Expensing all purchases as they happen, which understates profit in one period and overstates it in the next.
- Ignoring freight and import costs, which makes your margins look better than they are.
- Never reconciling counts, so phantom stock sits on the balance sheet.
- Mixing personal purchases with inventory (see our guide on keeping your books clean).
Small businesses with average annual gross receipts under an inflation-adjusted threshold (about $31 million for 2025 under IRC Section 448(c); confirm the current figure on IRS.gov) may be allowed to treat inventory as non-incidental materials and supplies or follow their book method. This can simplify things, but it is a decision to make with your tax professional.
How Ask For CPA Can Help
Inventory is where bookkeeping errors quietly become tax problems. Our team sets up and maintains inventory in QuickBooks and Xero, reconciles counts, and delivers monthly statements you can trust through our bookkeeping services and online accounting services. See our pricing or browse all services.
Frequently Asked Questions
Which inventory method is best for a small business?
FIFO is the most common choice because it is intuitive, widely accepted and the default in most software. Weighted average is a good alternative when items are interchangeable. The best method is the one you apply consistently.
Can I switch inventory methods?
Yes, but a change is an accounting method change. For tax purposes you generally need to file Form 3115 with the IRS. Talk to your CPA first.
Is inventory a tax deduction when I buy it?
Generally no. Inventory is deducted as COGS when it is sold, not when it is purchased. Unsold inventory remains an asset, except for qualifying small businesses with simplified treatment.
How often should I count inventory?
At minimum, once a year before closing the books. Businesses with high volume or shrinkage risk should count monthly or use cycle counts.
This article is general information, not tax or legal advice. Rules and thresholds change, so confirm your situation with a qualified CPA or the IRS.
Ready to get your inventory and books under control? Contact Ask For CPA today for a free consultation.
