The problem in plain numbers
Imagine you buy ten mugs at a lower price in January and ten more at a higher price in March. In April you sell twelve. Which cost do you assign to those twelve sales? There is no single physical answer, so accounting uses a method.
The method affects reported profit in a period of changing prices. It does not change the total cost paid over the life of the inventory, only when it reaches your profit and loss statement.
First in, first out
FIFO assumes the oldest units are sold first. In the mug example, the ten cheaper January mugs go out first and then two of the more expensive March ones. In rising price periods, FIFO gives a lower cost of goods and higher profit, and the ending inventory is valued near current prices.
It matches how many businesses physically move stock, especially anything that can expire, and it is widely accepted.
Last in, first out
LIFO assumes the newest units are sold first. In rising prices it shows higher cost of goods, lower profit and, for tax, may defer tax. But it is allowed only in some settings, has special tax rules and is not permitted under some accounting standards.
Most small businesses do not use it. If you think LIFO could help, speak with a CPA first, because changing methods needs formal steps and approval.
Weighted average cost
This method blends all purchases. Add up the total cost of units on hand and divide by the number of units to get an average cost, then apply that to sales. It is simple and smooths out price swings.
Many accounting programs for small businesses use average cost or FIFO by default. Check what yours does in the inventory settings before you rely on its reports.
Choosing and staying consistent
Pick the method that suits your products and tax advice, then use it consistently from year to year. Switching often makes comparisons meaningless. If you need to change, document the reason and tell your tax preparer.
Whatever you choose, back it with good records: purchase invoices, receiving dates and counts. The method only works if the quantities and costs behind it are accurate.
A numbers example with all three
Suppose ten units cost ten each and ten more cost fourteen each, and you sell twelve. Under FIFO the cost of goods sold is the ten at ten plus two at fourteen. Under LIFO it is the ten at fourteen plus two at ten. Under weighted average, the average cost is twelve per unit, so the cost of goods sold is a straight multiple of twelve. Three methods give three different profit figures from the same real purchases, which is why consistency and documentation matter so much.
Common questions
Which method is easiest for a small shop?
Average cost or FIFO, depending on your software. Both are widely used and easy to explain.
Does the method change my cash?
No. It changes reported profit and inventory value, not the money you paid.
Can I change inventory methods?
Possibly, but for tax purposes there are rules. Speak to your CPA before changing.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.