FIFO stands for First In, First Out. LIFO stands for Last In, First Out. Both are methods for calculating the cost of inventory you sell, and the difference between them comes down to which purchase price gets assigned to the items leaving your shelves.

A quick example makes this concrete. Say you buy 100 units in January at $5 each, then another 100 units in March at $7 each. In April you sell 100 units. Under FIFO, the cost of goods sold is $500 because you’re using the January price first. Under LIFO, the cost of goods sold is $700 because you’re using the most recent March price. Same products, same sale, but a $200 difference in reported cost.

That difference flows straight to your bottom line. FIFO shows lower costs and higher profit in this scenario. LIFO shows higher costs and lower profit. Neither is wrong. They’re just different assumptions about which inventory got sold.

The tax impact is where most business owners pay attention. When prices are rising, which they usually are over time, LIFO produces higher cost of goods sold and lower taxable income. That means a lower tax bill today. FIFO does the opposite. It shows more profit on paper, which means more taxes owed. If you’re looking at this purely from a small business tax return perspective, LIFO can defer taxes into future years when prices are climbing.

There are trade-offs though. FIFO gives you a balance sheet where inventory is valued closer to current market prices, which looks better to lenders and investors. LIFO can create an inventory value on your balance sheet that’s significantly lower than what the inventory is actually worth, especially if you’ve been using LIFO for years. Banks reviewing your financials for a loan will notice that.

Most small businesses use FIFO. It’s simpler to maintain, it matches how most businesses actually move product (oldest stock goes out first), and it’s the default method in QuickBooks. LIFO requires more detailed record-keeping and layer tracking that adds complexity to your books. LIFO also isn’t allowed under international accounting standards, though that only matters if you’re reporting internationally.

One important rule to know is that once you choose a method, you can’t freely switch between them. Changing your inventory method requires filing Form 3115 with the IRS for approval. So the decision is worth getting right from the start rather than guessing and hoping to change later.

There’s also a third option called weighted average cost, which blends all purchase prices together. For businesses with high volume and frequent purchasing, this can be simpler than tracking individual cost layers under FIFO or LIFO.

The right method depends on your business, your industry, and your goals. A retail shop with steady pricing and straightforward inventory might do perfectly well with FIFO and never think about it again. A business dealing with volatile material costs might benefit from a more deliberate inventory accounting strategy that accounts for price swings and their tax implications. Either way, the method you choose should be one you can maintain consistently and that gives you financial statements you can actually use to make decisions.