The Census Bureau tracked $2,740.2 billion in manufacturers' and trade inventories as of June 2026, with a 1.30 inventory-to-sales ratio, a clear signal of how much capital sits tied up in stock across the economy.
This guide covers the four inventory costing methods, how to calculate inventory cost correctly, and where inventory ends and COGS begins. Get the method wrong, and you risk distorted margins, messy tax filings, and comparisons that don't hold up year over year.
Key Takeaways
- FIFO, LIFO, WAC, and Specific Identification control how inventory costs move into COGS
- Your method choice directly affects reported profit, taxable income, and balance sheet value during price swings
- LIFO is allowed under US GAAP but banned under IFRS—a hard limit if you report internationally
- Switching methods later needs IRS Form 3115 approval and can break year-over-year comparisons
What Is Inventory Costing and Why Does It Matter?
Inventory costing is the accounting process of assigning material, labor, and overhead costs to the products a business holds and eventually sells. It rests on a cost flow assumption: a rule for allocating dollars, not a system for tracking which physical unit moved where.
Here's the core mechanic, straight from The CPA Journal's 2025 analysis: total cost of goods available for sale gets split between COGS and unsold inventory. Push more cost into COGS, and less remains in ending inventory. Push less into COGS, and ending inventory rises.
That single allocation decision ripples outward:
- Gross margin shifts depending on which costs hit COGS first
- Taxable income rises or falls with the same allocation
- Balance sheet asset value changes even though nothing physical happened
For B2B manufacturers and distributors managing thousands of SKUs, this allocation underpins accurate margins, tax positions, and balance sheet values.
What Are the Four Inventory Costing Methods?
FIFO (First In, First Out)
FIFO assumes the oldest inventory costs get used first. The formula: COGS = Cost of oldest units sold Ending inventory = Cost of most recently purchased units FIFO is accepted under both US GAAP and IFRS, per the IFRS Foundation's IAS 2 standard. During inflationary periods, FIFO typically produces lower COGS and higher reported profit, since older, cheaper costs move to the income statement first.
LIFO (Last In, First Out)
LIFO flips the assumption: newest costs get used first. COGS = Cost of most recently purchased units Ending inventory = Cost of oldest units still on hand KPMG's 2026 comparison of IFRS and US GAAP confirms LIFO remains a US GAAP option, but IAS 2 bans it outright. During rising prices, LIFO pushes higher costs into COGS and lowers taxable income. That tax benefit is useful for US filers, yet it is a dealbreaker for companies reporting under IFRS.
Weighted Average Cost (WAC)
WAC blends everything into one number: Average unit cost = Total cost of goods available ÷ Total units available Multiply that average by units sold for COGS, and by units remaining for ending inventory. WAC works best for commingled inventory—bulk materials like fasteners, resin, or raw metal—where individual units aren't distinguishable.
Specific Identification
This method tracks the exact cost of each individual item using serial numbers or lot codes. COGS = Actual cost of the specific units sold Ending inventory = Actual cost of the specific units still on hand It's the right fit for unique, high-value goods: custom machinery, serialized industrial equipment, or one-off fabricated parts where actual cost matters more than an assumption. Side-by-side example: Say a company starts with 100 units at $10 each ($1,000), then buys 100 more at $12 ($1,200). Total available: 200 units, $2,200. They sell 150 units.
| Method | COGS | Ending Inventory |
|---|---|---|
| FIFO | $1,600 (100@$10 + 50@$12) | $600 (50@$12) |
| LIFO | $1,800 (100@$12 + 50@$10) | $400 (50@$10) |
| WAC | $1,650 (150 × $11 avg) | $550 (50 × $11 avg) |
| Same units and purchases produce three different profit pictures under FIFO, LIFO, and WAC. Specific identification is omitted here because COGS depends on which exact units were sold, not on a cost-flow assumption. |
How Do You Calculate the Cost of Inventory?
The core formula, straight from IRS Publication 538:
Beginning Inventory + Purchases − Ending Inventory = Cost of Goods Sold
Worked example: A small industrial parts distributor starts the quarter with $50,000 in inventory. They purchase $30,000 more during the quarter. A physical count at quarter-end shows $35,000 remaining.
$50,000 + $30,000 − $35,000 = $45,000 COGS
Inventoriable costs go beyond the sticker price. Per IRS guidance, purchased-merchandise cost includes:
- Invoice price minus discounts
- Freight-in and transportation charges
- Direct labor (for manufactured goods)
- Applicable overhead required under uniform capitalization rules
One important distinction: carrying costs, like storage, insurance, and obsolescence, are separate from inventory cost. Those get expensed as incurred, not baked into the per-unit cost figure.
Manual tracking across hundreds of SKUs invites errors fast. Inventory and warehouse management software automates the cost roll-up so freight, labor, and overhead land in the right bucket without a month-end spreadsheet reconciliation.
Gushwork builds custom inventory and warehouse management systems for manufacturers and distributors that handle this cost roll-up automatically.
What's the Difference Between COGS and Inventory?
Inventory is a balance sheet asset, the value of unsold goods sitting in your warehouse. COGS is an income statement expense, the cost of goods you actually sold during the period.
As inventory sells, its cost migrates from the balance sheet to the income statement. Nothing stays in two places at once.
Quick example: A company buys $10,000 of inventory. It sells 60% of those goods during the period.
- Inventory (balance sheet): $4,000 remains as an asset
- COGS (income statement): $6,000 is recognized as an expense
For scale context, Walmart's fiscal 2026 Form 10-K reported $58,851 million in inventories at year-end alongside $350,360 million in cost of sales for the year. One's a snapshot; the other's a period total. The costing method is what determines how the split happens.
How Do You Choose the Right Costing Method for Your Business?
There's no universal answer. It depends on what you sell and how fast it moves.
- Perishable or fast-turnover goods (components, fasteners, consumables) typically suit FIFO, since older stock naturally moves out first.
- Unique or high-value items (custom equipment, serialized machinery) fit specific identification, where actual cost tracking matters.
- Commingled bulk goods often work best under WAC, especially when individual unit tracking isn't feasible.
Before committing, weigh three things:
- Tax impact: LIFO can reduce taxable income during inflation, but only if IRS rules allow it for your situation
- Industry norms: Match what similar manufacturers and distributors in your space already use
- Reporting complexity: Specific identification demands more granular tracking than WAC
Once you pick a method, stick with it. Changing later requires filing IRS Form 3115 and disrupts comparability across reporting periods. Model the tax and financial statement impact carefully before you switch.
Frequently Asked Questions
What are the four inventory costing methods?
The four methods are FIFO (oldest costs first), LIFO (newest costs first), Weighted Average Cost (blended unit cost), and Specific Identification (exact cost per item). Each allocates cost differently between COGS and ending inventory.
How do I calculate the cost of inventory?
Use Beginning Inventory + Purchases − Ending Inventory = Cost of Goods Sold. This formula, confirmed in IRS Publication 538, applies regardless of which costing method you choose.
What's the difference between COGS and inventory?
Inventory is a balance sheet asset representing unsold goods. COGS is an income statement expense representing the cost of goods actually sold during the period.
Can a business switch its inventory costing method later?
Yes, but it requires IRS approval, typically through Form 3115. Switching also disrupts year-over-year financial comparisons, so it should be modeled carefully first.
Is LIFO allowed everywhere?
No. LIFO is permitted under US GAAP but prohibited under IFRS's IAS 2 standard. Businesses operating internationally under IFRS cannot use it.
Which inventory costing method is best for a small business?
FIFO and Weighted Average Cost are the most common choices for small businesses. Both are simple to apply and compliant under GAAP and IFRS alike.
