How FIFO vs LIFO Can Skew a Company's Profits: A Guide for Stock Investors

Imagine you're analyzing a consumer electronics company as an investor. You notice the company buys laptops for resale, but wholesale prices fluctuate. One month, a laptop costs $1,000. The next, it's $1,200. When the company sells a laptop, how do they decide how much that unit "cost them" from an accounting standpoint?

The inventory costing method—FIFO, LIFO, or weighted average cost—can significantly affect reported profit margins, taxable income, and balance sheet inventory values. These differences directly impact how you interpret a company's financial health and performance.

Let's walk through these methods using a simple, real-world example.

Scenario Setup: A Laptop Reseller Example

Assume the company you’re analyzing buys and sells identical laptops. Here’s what their inventory looks like:

• Bought 1st laptop at $1,000
• Bought 2nd laptop at $1,100
• Bought 3rd laptop at $1,200
• Then, they sell 1 laptop for $1,500

We’ll see how the reported Cost of Goods Sold (COGS), ending inventory, and profit change depending on the method used.

FIFO: First-In, First-Out

Under FIFO, the oldest inventory is assumed to be sold first. So, when the company sells a laptop:

• COGS = $1,000 (the first one purchased)
• Ending inventory = $1,100 + $1,200 = $2,300
• Profit = $1,500 - $1,000 = $500

FIFO is intuitive and matches the physical flow in many businesses. In times of rising prices, FIFO reports higher profits and higher inventory values.

LIFO: Last-In, First-Out

With LIFO, the most recently purchased inventory is sold first. For the laptop sale:

• COGS = $1,200 (the last one purchased)
• Ending inventory = $1,000 + $1,100 = $2,100
• Profit = $1,500 - $1,200 = $300

LIFO typically leads to lower profits and lower taxes in inflationary environments. However, it’s not allowed under IFRS, so it's only used by U.S.-based companies under GAAP.

Weighted Average Cost

Weighted average cost calculates the average cost per unit:

• Average Cost = ($1,000 + $1,100 + $1,200) / 3 = $1,100
• COGS = $1,100
• Ending inventory = $1,000 + $1,100 + $1,200 - $1,100 = $2,200
• Profit = $1,500 - $1,100 = $400

Weighted average cost smooths out price fluctuations and is commonly used when inventory is indistinguishable or when simplicity is valued.

Where to Find a Company's Inventory Costing Method in SEC Filings

Public companies must disclose their inventory accounting methods in their annual reports (10-K for U.S. companies, 20-F for foreign ones). Look in:

• Item 8 – Financial Statements and Supplementary Data
• Notes to the Financial Statements, under headings like:
  • "Inventories"
  • "Summary of Significant Accounting Policies"

Example: CROX (Crocs, Inc.) 10-K

In 10-K filing for 2024, Crocs write:

Inventories are comprised of finished goods, are stated at the lower of cost or net realizable value, and are recognized using the first-in-first-out method of inventory costing.

This tells investors that Crocs uses FIFO for inventory costing.

Why Investors Should Care

Inventory costing affects:

• Profitability metrics (like gross margin)
• Tax liabilities
• Comparability across peers
• Cash flow visibility

If a company changes methods (e.g., from FIFO to LIFO), it must disclose and justify the change. However, such changes can be used to manage earnings, reduce taxes, or manipulate financial appearance, especially if done near key events like IPOs or earnings releases.

Investors should be cautious when:

• A company changes its method without a clear operational reason.
• It repeatedly switches methods.
• Gross margins change abruptly without business justification.

Summary: Comparison Table

Final Thoughts

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While inventory costing is an accounting technicality, it can reveal a lot about how a business operates, manages taxes, and presents its financial health. As an investor, being aware of these methods—and knowing where to look in financial filings—helps you interpret financials more critically and avoid surprises.

Always dig into the footnotes. That’s where the real story lives.