FIFO vs. LIFO vs. Weighted Average: Which Inventory Method to Use

FIFO, LIFO, and weighted average sound like accounting trivia. They're not. The method you pick changes your reported batch costs, your gross margin, your tax exposure, and the price floor you're willing to quote customers. Picking the wrong one is one of those errors that quietly distorts every operational decision for years.

Here's what each method actually does in a manufacturing context — with the kind of example that makes the difference obvious.

FIFO: First In, First Out

FIFO assumes the oldest material is consumed first. When raw prices are rising, FIFO produces lower COGS (because you're costing out at older, cheaper prices) and higher reported margins. Physically, it's also the right choice for any material with shelf life — food, chemicals, anything that ages. For most SME factories in stable-or-rising-price categories, FIFO is the default that matches both accounting clarity and warehouse reality.

LIFO: Last In, First Out

LIFO assumes the newest material is consumed first. In rising-price environments, LIFO produces higher COGS and lower reported margins — which can lower tax liability in jurisdictions that allow it. Indian Income Tax does not permit LIFO for tax reporting; most factories here can ignore it entirely. Even where allowed, LIFO mismatches physical flow for most products and complicates inventory valuation.

Weighted Average: The Pragmatic Default

Weighted average pools all units of a SKU and divides total cost by total quantity, producing a single blended cost per unit. The math is simple: `new average = (old qty × old cost + new qty × new cost) ÷ total qty`. It smooths out price volatility, makes batch costing straightforward, and matches how most ERPs prefer to operate.

A Worked Example

You buy 100 kg of resin at ₹120/kg, then 100 kg at ₹140/kg. You consume 100 kg. Under FIFO, COGS = ₹12,000 (you used the older, cheaper batch). Under LIFO, COGS = ₹14,000 (you used the newer, costlier batch). Under weighted average, the blended cost is ₹130/kg, so COGS = ₹13,000. The remaining inventory is valued differently in each case — and that's the number that flows into your balance sheet.

How to Choose

Use FIFO if your material has shelf life or your industry is price-stable. Use weighted average if raw prices fluctuate frequently and you want stable batch costs for quoting. Avoid LIFO unless your tax structure specifically rewards it. Whichever you pick, pick once and document it — switching methods retroactively is an accounting nightmare and a red flag to auditors.