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Inventory Accounting Methods for Small Businesses: FIFO, LIFO, and Average Cost

By Yarik Yarosh, CPA ·September 5, 2026 ·Updated October 4, 2026 ·5 min read
Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Inventory accounting determines when the cost of goods is deducted. A retailer buying $100,000 in inventory and selling $80,000 worth by December 31 has $20,000 in unsold inventory. Under accrual accounting, only the $80,000 cost of goods sold (COGS) is deductible; the $20,000 in unsold inventory is an asset on the balance sheet (not deductible until sold). The method used to value inventory (FIFO, LIFO, or average cost) affects which $80,000 of costs are in COGS and which $20,000 remain in inventory, which directly affects taxable income.

✓Key takeaway

The small business exception (most important rule):

Under IRC 471(c), businesses with average annual gross receipts of $32 million or less (3-year average, for 2026) can treat inventory as non-incidental materials and supplies. This means:

  • Deduct the cost when purchased (not when sold)
  • No formal inventory accounting required
  • No need to calculate COGS
  • No need to choose FIFO, LIFO, or average cost
  • Cash method allowed regardless of inventory

This exception covers almost all small businesses. A retailer, manufacturer, or contractor with $32 million or less in receipts can simply deduct materials and supplies when purchased. The rest of this article applies to businesses that exceed the threshold or choose accrual accounting for other reasons.

FIFO (First In, First Out):

  • Oldest inventory costs are assigned to COGS first
  • Ending inventory is valued at the most recent purchase prices
  • In a period of rising prices: COGS is lower (older, cheaper costs), taxable income is HIGHER
  • In a period of falling prices: COGS is higher, taxable income is lower
  • Most intuitive method; matches the physical flow of most businesses
  • Required for financial reporting under IFRS (but not required for US tax)

LIFO (Last In, First Out):

  • Newest inventory costs are assigned to COGS first
  • Ending inventory is valued at the oldest purchase prices
  • In a period of rising prices: COGS is higher (newer, more expensive costs), taxable income is LOWER
  • Tax advantage during inflation: reduces current-year taxes
  • LIFO conformity rule: if you use LIFO for tax, you must also use LIFO for financial statements
  • Not available for businesses using the simplified cash method under IRC 471(c)
  • Requires maintaining detailed LIFO layers (complex bookkeeping)

Weighted Average Cost:

  • Total cost of goods available for sale / total units = average cost per unit
  • COGS and ending inventory are both at the average cost
  • Simplest calculation for businesses with homogeneous inventory
  • Produces results between FIFO and LIFO
  • Common in food service, chemical, and bulk material businesses

When does inventory method choice matter?

Which inventory costing method should my business use?

The three primary methods are FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost. FIFO assumes the oldest inventory is sold first, which produces lower cost of goods sold and higher taxable income during periods of rising prices. LIFO assumes the newest inventory is sold first, which produces higher cost of goods sold and lower taxable income during inflation, but LIFO requires a LIFO conformity rule (you must use LIFO for financial reporting if you use it for tax). Small businesses with average gross receipts of $32 million or less (for 2026) can use the cash method and avoid accounting for inventory under IRC 471, treating inventory costs as materials and supplies deductible when consumed. Changing your inventory method requires filing Form 3115 and computing a Section 481(a) adjustment to prevent double-counting or omitting income during the transition.

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Cite this page

Yarik Yarosh, CPA. "Inventory Accounting Methods for Small Businesses: FIFO, LIFO, and Average Cost." Blue Cloud CPA, September 5, 2026, updated October 4, 2026. https://bluecloudcpa.com/guides/small-business-inventory-fifo-lifo-average-cost

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This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.