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What is the difference between FIFO, LIFO, and Average Cost?

The difference between these three inventory methods is in the way Cost of Good Sold (COGS) is calculated. A company typically does not track every single piece of inventory when it is sold, but assumes a general order that the inventory is sold, thus creating the total COGS for the accounting period. Consider the following explanations and example.

To understand First-In, First-Out (FIFO) inventory method, consider the purchase of milk at your local grocery store. When you grab a carton of milk, you are buying the first milk that was placed on the rack, not the most recent milk. The first milk carton placed on the rack (first in) is the first milk carton (first out) sold.

To understand Last-In, First-Out (LIFO) inventory method, consider the sale of a screw at a hardware store. When the hardware store replenishes the bucket of screws, the last screw to be placed on the pile (last in) is the first screw grabbed and purchased (First Out). Companies need to be aware of LIFO liquidation and how it will affect their income statement.

The understand the average cost method, it is fairly straight forward. A company is not worried about the order in which inventory is sold. Rather, the company the company computes an average cost of their inventory as a whole and assigns the average cost to each piece of inventory sold.

Imagine a company buys two gallons of milk, each at different prices, then sells one to a customer.

Jan. 3rd - (1) milk @ $1.50
Jan. 7th - (1) milk @ $2.00

Cost of Goods Sold for the sale of (1) milk
 FIFOLIFOAverage Cost