FIFO vs Average Cost, How Your Inventory Method Changes Reported Profit
How the IRS-recognized FIFO and average cost inventory methods produce different taxable profit on the same sales, shown with a worked example.
Two shop owners can sell the exact same products for the exact same prices and still report different taxable profit, simply because they value their leftover inventory differently. The IRS recognizes several accounting methods for this, and the one you pick changes the cost of goods sold figure on your return, which is why the choice matters even for a one-person shop.
The method, not the sale, decides the number
IRS Publication 538 lays out the identification methods available once you can no longer match a sold item to its exact original invoice (which is most small shops buying the same product in repeated batches). The two most common are:
FIFO (first-in, first-out). This method assumes the units you bought or produced first are the ones sold first. According to the IRS, "the items in inventory at the end of the tax year are matched with the costs of similar items that you most recently purchased or produced." In other words, your ending inventory is valued at your newest purchase costs, and your cost of goods sold reflects your oldest, often cheaper, purchase costs.
Average cost. Rather than tracking purchase order, this method blends all your costs for a given item into a single average, and applies that average to every unit sold or left in stock, regardless of when it was actually bought.
The IRS also recognizes LIFO (last-in, first-out), but that method requires filing Form 970 to adopt and carries more bookkeeping overhead, so most small shops that don't specifically need it stick with FIFO or average cost. The IRS is direct about why the method matters: "each method produces different income results, depending on the trend of price levels at the time. In times of inflation, when prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher."
A worked example
Say a shop buys the same candle in three batches over the year as the wholesale price rises, then sells 150 units at $10 each.
| Batch | Units bought | Cost per unit |
|---|---|---|
| 1 | 100 | $4.00 |
| 2 | 100 | $5.00 |
| 3 | 100 | $6.00 |
Total units bought: 300. Total cost: $1,500. Average cost per unit: $5.00.
Under FIFO, the 150 units sold are assumed to come from the earliest, cheapest batches first: all 100 units from Batch 1 ($400) plus 50 units from Batch 2 ($250), for a cost of goods sold of $650. The 150 units left in inventory are valued at the newer, pricier batches: 50 units from Batch 2 ($250) plus all 100 units from Batch 3 ($600), for an ending inventory value of $850.
Under average cost, cost of goods sold for 150 units is simply 150 × $5.00 = $750, and the 150 units remaining are also valued at 150 × $5.00 = $750.
| Method | Cost of goods sold | Gross profit on $1,500 revenue |
|---|---|---|
| FIFO | $650 | $850 |
| Average cost | $750 | $750 |
On identical sales and identical purchases, FIFO reports $100 more gross profit than average cost in this rising-price scenario, because it pushes the higher-cost batches into ending inventory rather than into the cost of what was sold. That $100 difference is taxable income that exists purely because of the accounting method, not because the shop actually performed differently.
Why this isn't just a bookkeeping footnote
In a period of rising supplier costs, which is the normal direction for most small retail and craft inventory over time, FIFO will consistently show higher reported profit (and so a higher tax bill in the current year) than average cost, because it defers the higher recent costs into inventory still sitting on the shelf. In a period of falling costs, this reverses. The IRS notes this explicitly, and it is the main reason the method is a real decision rather than a formality.
There is also a practical threshold worth knowing: the IRS lets qualifying small business taxpayers (generally those with average annual gross receipts of $25 million or less over the prior three years, under IRC section 471) skip formal inventory accounting for tax purposes and instead treat inventoriable items as non-incidental materials and supplies, using whichever of specific identification, FIFO, or average cost they choose. This threshold covers the overwhelming majority of one-person and small-team shops, which means the FIFO-versus-average-cost choice is usually a genuine election, not something locked in by your revenue size.
What to actually do with this
- Once you adopt a method, the IRS requires you to apply it consistently from year to year; switching later generally requires requesting a formal accounting method change.
- If your supplier costs are rising and you want to show a leaner current-year profit, average cost smooths out the effect of the most recent price increases. If you want ending inventory valued closer to replacement cost, FIFO does that.
- Whichever method you pick, the underlying cash in your bank account is identical. Only the reported figures on your tax return change, which is exactly why this is worth understanding rather than letting bookkeeping software default you into one silently.
Key takeaways
- FIFO values cost of goods sold using your oldest purchase costs and ending inventory using your newest costs; average cost blends all purchase costs into one per-unit figure for both.
- On a simple $4 to $6 per unit example with 150 of 300 units sold, FIFO shows $850 gross profit versus $750 under average cost, a $100 difference from the method alone.
- In a rising-cost environment, FIFO tends to show higher profit than average cost; in a falling-cost environment, the effect reverses.
- Businesses with average annual gross receipts of $25 million or less over the prior three years generally qualify to choose their inventory method for tax purposes without being forced into complex inventory accounting.