FIFO Inventory Method: Costs, Taxes, and Recordkeeping

The First-In, First-Out (FIFO) inventory method assigns the cost of your oldest stock to each sale first, leaving your most recent purchases sitting on the balance sheet as ending inventory. It is the default cost-flow method under U.S. Generally Accepted Accounting Principles and the only one permitted under International Financial Reporting Standards, which makes it the most widely used inventory method in the world. When prices are rising, FIFO tends to produce lower cost of goods sold, higher reported profit, and a bigger tax bill than the alternatives.

How FIFO Assigns Costs

Picture a grocery dairy case. Workers stock new cartons from the back so customers reach the oldest ones first. FIFO accounting works the same way on paper: when you record a sale, the cost attached to it comes from the earliest purchase still on your books, regardless of which physical unit actually left the shelf. The next sale pulls from the next-oldest cost layer, and so on.

Your actual products don’t have to move in this order. A hardware store might ship a bolt from last week’s delivery before one from last month’s, and that’s fine. FIFO is a cost-flow assumption, not a warehousing rule. It controls the dollar amounts that hit your income statement, not the boxes that go on the truck. Because it clears the oldest costs first, FIFO keeps the inventory figure on your balance sheet close to current market prices, which is one reason lenders and investors tend to favor it.

A FIFO Calculation, Start to Finish

Suppose your business makes two purchases of the same product during the month:

January 1: 10 units at $5 each ($50 total)
January 15: 10 units at $7 each ($70 total)

You now have 20 units on the books at a combined cost of $120. During January you sell 12 units. Under FIFO, the cost of those 12 units comes from the oldest inventory first: all 10 units from the January 1 batch at $5 each ($50), then 2 units from the January 15 batch at $7 each ($14). Cost of goods sold (COGS) for the month is $64.

That leaves 8 units from the January 15 purchase still in stock, all valued at $7. Ending inventory is $56. The math checks out: $64 in COGS plus $56 in ending inventory equals the $120 you originally spent. Auditors verify FIFO numbers exactly this way, and any mismatch signals a recording error worth investigating immediately.

What FIFO Does to Profit and Taxes

FIFO’s financial impact shifts dramatically with the direction of prices. Understanding that relationship is the key to deciding whether the method serves your business well.

When Prices Are Rising

When suppliers raise prices over time, FIFO sends the older, cheaper costs to your income statement first. COGS is lower, gross profit is higher, and ending inventory reflects the newer and more expensive purchases, so the balance sheet looks strong. The catch is that those higher reported profits are taxable, and the cash you need to replace the sold inventory has gone up.

The gap between reported profit and economic reality is sometimes called phantom profit. If you sold a widget that cost you $5 but replacing it now costs $8, the $3 difference is profit on paper but not in your bank account. Once you adjust for replacement cost, economic earnings under FIFO come in below what LIFO would show during inflationary periods. That tax hit on inflated profits is the single biggest reason some companies avoid FIFO in favor of LIFO when prices trend upward.

When Prices Are Falling

Deflation reverses the picture. The oldest inventory now carries the highest cost, so FIFO pushes those expensive layers into COGS first. Reported profits shrink, and ending inventory reflects the lower, more recent prices. The upside is a smaller tax bill. The downside is weaker-looking financial statements, which can matter when you’re trying to secure financing or attract investors.

FIFO Compared to LIFO and Weighted Average

FIFO is not the only option. Two alternatives show up regularly, and knowing how they differ helps you evaluate the fit.

LIFO (Last-In, First-Out)

LIFO does the opposite of FIFO: it assigns the most recent purchase costs to sales first. During inflation that means higher COGS and lower taxable income, which is the main reason companies adopt it. The trade-off is that LIFO leaves ancient, potentially misleading costs sitting on the balance sheet as ending inventory. LIFO also comes with a regulatory string attached. Under the LIFO conformity rule, if you use LIFO for your tax return you must also use it for financial reporting to shareholders and creditors.¹ FIFO has no equivalent restriction. LIFO is also prohibited under International Financial Reporting Standards, so companies reporting under IFRS have no choice but to use FIFO or weighted average.

Weighted Average Cost

The weighted average method recalculates a single average cost per unit every time you make a new purchase, then applies that blended cost to both sales and remaining inventory. The result is smoother financial statements with less period-to-period volatility. Manufacturing operations that mix raw materials together, making it impractical to track individual purchase lots, often gravitate toward this method. Averaging can obscure actual cost trends, though, which makes margin erosion harder to spot early.

The Small Business Inventory Exemption

Not every business has to follow the formal inventory accounting rules under federal tax law. If your average annual gross receipts over the prior three tax years fall at or below the small business threshold, you qualify for a simplified approach that can save significant bookkeeping effort.

The base threshold is $25 million, adjusted annually for inflation.² For tax years beginning in 2026, the inflation-adjusted figure is $32 million.³ Businesses meeting this test are exempt from the general inventory requirements and can choose one of two simplified approaches:⁴

Treat inventory as non-incidental materials and supplies, deducting the cost when items are used or sold rather than capitalizing them first.
Match tax treatment to the inventory method used in your applicable financial statement (or, if you have none, to your own books and records).

Tax shelters are excluded from this exemption regardless of their gross receipts. Sole proprietors and other non-corporate taxpayers apply the gross receipts test separately to each trade or business, as though each one were its own entity.⁴

Switching To or Away From FIFO

Once you pick an inventory method, federal tax law requires you to stick with it unless the IRS consents to a change. The consent requirement comes directly from the tax code: you must secure the Secretary’s approval before computing taxable income under a new method.⁵ The vehicle for requesting that approval is Form 3115, Application for Change in Accounting Method.⁶

Form 3115 is not a casual filing. You provide all relevant information about the proposed change, attach copies of related contracts and agreements, compute the required adjustment amount, and, for non-automatic changes, build a full legal argument for why the new method is appropriate.⁶ Skipping the step is risky: the tax code states that failure to request consent will not reduce any penalty or addition to tax that would otherwise apply.⁵

The Section 481(a) Adjustment

When you switch methods, the IRS doesn’t want income double-counted or skipped entirely during the transition. The section 481(a) adjustment closes that gap by requiring you to account for the cumulative difference between the old and new methods.⁷

If the adjustment increases your taxable income (a positive adjustment), you generally spread it over four tax years: the year of the change plus the next three. If the adjustment decreases your taxable income (a negative adjustment), you take it all in the year of the change. There is a shortcut for smaller positive adjustments: if the amount is less than $50,000, you can elect to recognize the entire adjustment in one year instead of four.⁸

Penalties for Unauthorized Changes

Changing your inventory method without IRS consent can trigger accuracy-related penalties of 20% of the resulting underpayment for negligence or a substantial understatement of income.⁹ If the IRS determines the change was fraudulent, the penalty jumps to 75% of the underpayment attributable to fraud.¹⁰ Interest accrues on top of either penalty. The 75% rate is rare and reserved for intentional wrongdoing; the 20% negligence penalty is a realistic risk for any business that simply switches methods without filing Form 3115.

Writing Down Inventory Under FIFO

Inventory doesn’t always hold its value. Damage, obsolescence, style changes, and overstock can push an item’s recoverable value below what you paid for it. Under GAAP, FIFO users apply the lower of cost or net realizable value test: if an item’s estimated selling price minus the costs to complete and sell it falls below its recorded FIFO cost, you write the inventory down to that lower figure. LIFO users follow a slightly different rule that uses “market” value instead of net realizable value.

The IRS has its own requirements for writing down what it calls subnormal goods, meaning items that are unsalable at normal prices due to damage, defects, style changes, or similar issues. Finished goods in this category must be valued at the actual selling price minus disposal costs, and you must have offered them at that price within 30 days of the inventory date. Raw materials or partly finished goods must be valued based on usability and condition, but never below scrap value. Completely unsalable items should be removed from inventory entirely.¹¹

The burden of proof falls on you. The IRS expects documentation showing actual sales, offering prices, or contract cancellations to back up any reduced valuation.¹¹ Aggressive write-downs without supporting evidence are a frequent audit target.

Records FIFO Requires

Your inventory method is only as defensible as the records behind it. Federal regulations require you to maintain books of account sufficient to establish your gross income, deductions, and credits, and those records must be available for IRS inspection at all times.¹² For FIFO specifically, that means keeping purchase invoices tied to specific cost layers, sales receipts, and physical count documentation.

The retention period depends on your situation rather than a single fixed number. Generally you keep records for at least three years after filing the return they support. That period extends to six years if you underreport gross income by more than 25%, and there is no time limit at all for fraudulent or unfiled returns.¹³ Many tax professionals recommend keeping inventory records for at least seven years, since the IRS can reach further back than three years in common scenarios.

The consistency requirement under federal tax law means your chosen inventory method must be applied the same way from year to year.¹¹ Your records need to demonstrate exactly that consistency. Auditors trace individual purchase lots through your cost layers and match them against sales records. If the paper trail breaks down, you lose the ability to prove your COGS figures are correct, which puts you in a weak position regardless of whether your numbers were actually right.

1
eCFR. 26 CFR 1.472-2 – Requirements Incident to Adoption and Use of LIFO Inventory Method
2
Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
3
Internal Revenue Service. Revenue Procedure 2025-32
4
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
5
Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting
6
Internal Revenue Service. Instructions for Form 3115
7
Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting
8
Internal Revenue Service. IRM 4.11.6 – Changes in Accounting Methods
9
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
10
Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty
11
Internal Revenue Service. Lower of Cost or Market (LCM) – Practice Unit
12
eCFR. 26 CFR 1.6001-1 – Records
13
Internal Revenue Service. Publication 583 – Starting a Business and Keeping Records