FIFO vs LIFO vs AVCO: Which Inventory Costing Method Is Right for Your Retail Business?

Why Your Inventory Costing Method Matters

Every time you sell a product, your accounting system needs to record the cost of that product as cost of goods sold (COGS). The question is: which cost? If you bought the same item three times at different prices, which purchase price applies to the unit you just sold?

This is not a theoretical accounting question. The answer directly affects your gross margin calculation, your ending inventory valuation on the balance sheet, and your taxable income. In a period of rising costs, the difference between costing methods can shift reported profit by thousands of dollars per month for a mid-sized retailer.

Three methods dominate retail accounting: FIFO (first-in, first-out), LIFO (last-in, first-out), and AVCO (average cost, also called weighted average cost). Each produces different results from the same underlying purchase and sales data. Understanding those differences is essential before choosing a method, because changing your costing method mid-stream requires accounting adjustments and in some cases regulatory approval.

FIFO: First-In, First-Out

FIFO assumes that the oldest inventory is sold first. The cost assigned to each sale is the cost of the earliest unsold unit in your inventory record. As older units are sold, newer units move up the queue.

In practice, FIFO mirrors physical inventory flow for most perishable and dated-inventory retailers. If you sell bread, dairy, or pharmaceuticals with expiry dates, you are already physically moving older stock first. FIFO accounting matches that physical reality, which simplifies reconciliation.

The financial statement impact of FIFO depends on whether costs are rising or falling. When purchase costs are rising (inflation), FIFO produces a lower COGS because you are matching older, cheaper purchase prices to current sales. Lower COGS means higher reported gross profit and higher taxable income. Your ending inventory balance on the balance sheet will also be higher, reflecting the more recent, higher-cost units that remain unsold.

FIFO is the required method in Canada and most countries outside the United States. The International Financial Reporting Standards (IFRS), which Canadian public companies follow and which most Canadian accounting software is built around, prohibit LIFO. Private Canadian businesses following ASPE (Accounting Standards for Private Enterprises) are also generally expected to use FIFO or average cost. FIFO is the safe default for Canadian retailers.

• Oldest units are assigned to COGS first
• Produces higher gross profit in rising-cost environments
• Ending inventory reflects most recent (higher) purchase costs
• Required under IFRS; standard for Canadian retailers
• Matches physical flow for perishable and expiry-dated inventory

LIFO: Last-In, First-Out

LIFO assumes that the most recently purchased inventory is sold first. The cost assigned to each sale is the cost of the most recent purchase batch, regardless of physical flow.

LIFO is primarily a US tax strategy. When purchase costs are rising, LIFO assigns higher recent costs to COGS, which reduces reported gross profit and taxable income. This is the appeal: in inflationary environments, LIFO provides a real tax deferral benefit.

The trade-off is that LIFO produces a distorted balance sheet. Ending inventory under LIFO is valued at old, often very old purchase costs, not current market values. For retailers who have used LIFO for many years, the LIFO reserve (the cumulative difference between LIFO and FIFO inventory values) can be enormous. This makes financial ratios like current ratio and inventory turnover difficult to interpret accurately.

LIFO is prohibited under IFRS and is not permitted for Canadian retailers filing under either IFRS or ASPE. If your accounting software was built for the US market, it may offer LIFO as a costing option. You should not use it if you are a Canadian business. Your accountant and the CRA will expect FIFO or average cost.

AVCO: Average Cost (Weighted Average)

AVCO assigns a weighted average cost to every unit in inventory. Each time you receive new stock, the average cost per unit is recalculated: (total cost of all units in inventory) / (total units in inventory). Every subsequent sale uses this updated average until the next receipt changes it.

AVCO smooths out the cost volatility that FIFO and LIFO produce. If your purchase prices fluctuate significantly from order to order, AVCO produces steadier COGS figures and more stable gross margins, which makes financial planning easier.

The limitation of AVCO is that it can obscure margin issues at the lot or batch level. If a specific purchase batch came in at significantly higher cost due to supply chain disruption, AVCO spreads that cost increase across all units rather than reflecting it in the batch's contribution to margin. For businesses with highly variable purchase prices or significant cost events, FIFO's lot-level visibility may be more informative.

AVCO is widely used in retail, particularly for commodity goods, consumables, and high-volume SKUs where tracking individual lot costs adds operational complexity without proportionate analytical value.

• Recalculates average cost per unit after every receipt
• Produces stable COGS and gross margins regardless of purchase price fluctuation
• Less lot-level cost visibility than FIFO
• Well-suited for commodity goods and high-volume SKUs
• Permitted under both IFRS and ASPE for Canadian businesses

Comparing the Three Methods: A Worked Example

Consider a retailer who makes three purchases of the same product: 100 units at $10, 100 units at $12, and 100 units at $14. They then sell 150 units.

Under FIFO: the first 100 units sold are costed at $10 (the first purchase), and the next 50 are costed at $12 (the second purchase). Total COGS = $1,000 + $600 = $1,600. Ending inventory = 50 units at $12 + 100 units at $14 = $600 + $1,400 = $2,000.

Under LIFO: the first 100 units sold are costed at $14 (the most recent purchase), and the next 50 are costed at $12. Total COGS = $1,400 + $600 = $2,000. Ending inventory = 50 units at $12 + 100 units at $10 = $600 + $1,000 = $1,600.

Under AVCO: the average cost is (100 x $10 + 100 x $12 + 100 x $14) / 300 = $3,600 / 300 = $12.00 per unit. 150 units sold at $12 = COGS of $1,800. Ending inventory = 150 units at $12 = $1,800.

In this rising-cost scenario: FIFO produces the lowest COGS and highest profit; LIFO produces the highest COGS and lowest profit; AVCO falls in the middle. The differences are real money, and they persist across every accounting period in which purchase costs are not flat.

Which Method Should You Choose?

For most Canadian retailers, the practical choice is between FIFO and AVCO, since LIFO is not permitted. The decision comes down to your product type and your analytical priorities.

Choose FIFO if you sell perishable goods, pharmaceuticals, food, or any product with expiry dates. FIFO matches physical reality for these categories, simplifies lot-level traceability, and is required for any business operating under IFRS. FIFO is also the cleaner choice if you want to track batch-level margins or manage recall risk with lot and serial number traceability.

Choose AVCO if you sell commodity goods, construction materials, bulk consumables, or other products where individual lot cost tracking does not add meaningful analytical value. AVCO reduces per-transaction accounting complexity and smooths out margin volatility from purchase price fluctuations.

Whatever method you choose, document it in your accounting policies and apply it consistently. Changing costing methods mid-year or between years requires disclosure and in some cases a prior-period restatement. Your inventory management system must support the method you choose, and the COGS it generates must flow correctly into your general ledger and financial statements.