First-in, first-out (FIFO)

This method allows you to assume that the first items put into inventory are the first ones out the door. Using the example above, you know you have sold 2,010 units. This means that you have sold all 500 of the $12.50 units, all 1,250 of the $13.10 units, and 260 of the $12.16 units. That leaves you with inventory of 115 of the $12.16 units and all 950 of the $14.25 units. Your total inventory value is therefore $14,935.90.

FIFO is the costing method used by most businesses. It makes sense when you think about it, as you will most likely rotate your stock; that is, you will sell your oldest stock first to keep your products in good condition.

In times of changing prices, FIFO gives you the inventory valuation most resembling replacement value, because the inventory items are costed at the most recent costs.

Last-in, first-out (LIFO)

This method is the opposite of FIFO. It assumes that your most recent purchases are the first ones you sold. Under the LIFO method, you would have sold all 950 of the $14.25 units, all 375 of the $12.16 units, and 685 of the $13.10 units. This leaves you with an inventory of 565 of the $13.10 units and all 500 of the $12.50 units, giving you a total inventory cost of $13,651.50.

LIFO is the method that provides you with the most accurate picture of your gross margin because the items at the most recent cost are the ones applied to the revenues. However; it can leave an extremely distorted picture of the inventory value. If you always have rising inventory levels, you may end up with inventory valued on the balance sheet at prices that are 10 or 20 years old. These values never" clear out" of the inventory. If, for some reason, sales are higher than current production, you will "dip" into that old layer, and the COGS on the income statement will bear extremely little resemblance to reality.

LIFO is quite a popular method of costing in the United States, but in Canada is disallowed for taxation purposes, and therefore is not used in Canada.