# How do I decide what my inventory is worth — which costing method should I use, and can I change it later?

Applies to: United States · Updated 2026-09-27

A costing method decides how the cost of goods bought at different prices is split between goods sold and goods left; it is an assumption about cost, not a record of which unit left the shelf. For tax, the IRS describes specific identification, FIFO and LIFO (LIFO by election) and accepts a rolling average under conditions. Check what your books and last return actually use. Changing later generally needs IRS consent through Form 3115.

## What does a costing method decide, and does it have to follow the shelf?

When identical units are bought at different prices and mixed together, a sale does not show which price it used up. A costing method settles that: it assigns part of the total cost to the goods sold and the rest to the goods still on hand, and that remainder is the value of your inventory.

The method is an assumption about cost, not a record of which box left the building. IRS Revenue Procedure 2008-43 says a taxpayer valuing inventory uses a cost-flow assumption, such as FIFO or LIFO, to identify the items in ending inventory. Section 472 of the Internal Revenue Code shows this plainly for LIFO: the goods on hand at year-end are treated as being, first, those from the opening inventory, whichever units are physically on the shelf. Rotating stock oldest-first is an operating choice; it does not fix your costing method, and a change of method never means rearranging the warehouse.

## How does each method split the cost?

The methods differ in the rule that decides which cost leaves with a sale:

- **Specific identification.** Each unit keeps its own purchase cost, and a sale removes exactly that cost. IRS Publication 538 says to use it when you can identify and match the actual cost to the items in inventory.
- **First-in, first-out (FIFO).** Publication 538 says FIFO assumes the items you purchased or produced first are the first ones sold, so the goods left carry the latest costs.
- **Last-in, first-out (LIFO).** Publication 538 says LIFO assumes the items purchased or produced last are the first ones sold, so the goods left carry the oldest costs.
- **Average cost.** Revenue Procedure 2008-43 describes a rolling average cost for each inventory item, recomputed as you buy or produce more units or on a regular basis; the units sold and the units left carry that average.

## How much does the choice change the numbers?

Suppose you buy 30 identical units in three lots of 10, at 20.00, 24.00 and 31.00 each (750.00 in total), and after the last lot arrives you sell 18 units at 40.00 each (720.00 of sales). Each method splits the 750.00 differently:

| Method | Cost of goods sold (18 units) | Goods left (12 units) | Gross profit |
|---|---|---|---|
| FIFO | 392.00 | 358.00 | 328.00 |
| Average cost (25.00 a unit) | 450.00 | 300.00 | 270.00 |
| LIFO | 502.00 | 248.00 | 218.00 |
| Specific identification (only if each unit carries a lot or serial mark tying it to its invoice: 5 sold from lot 1, 5 from lot 2, 8 from lot 3) | 468.00 | 282.00 | 252.00 |

Publication 538 allows the last row only where each unit sold can be matched to its own invoice, and points intermingled goods that cannot be identified with specific invoices to FIFO or LIFO.

Every row adds back to 750.00; only the split between this period's profit and the value carried forward changes. With rising prices, FIFO leaves the newest costs on hand and shows the highest profit, and LIFO does the reverse. How purchases and cost of goods sold are posted is covered in a separate question.

## Which methods can a U.S. business use for tax, and on what conditions?

IRS Publication 538 says to use FIFO or LIFO if you cannot specifically identify items with their costs, or if the same type of goods are intermingled in your inventory and cannot be identified with specific invoices. Whatever method you use, Publication 538 says it must conform to generally accepted accounting principles for similar businesses and must clearly reflect income.

LIFO carries its own conditions:

- Publication 538 says to file Form 970, or a statement with all the information Form 970 requires, with your timely filed return for the first year you use LIFO, and warns that the LIFO rules are very complex.
- Section 472 of the Internal Revenue Code requires goods under LIFO to be inventoried at cost.
- Section 472 says that once LIFO is used, it must be used in all later years unless the IRS approves a change to a different method.

Average cost on the return is addressed by IRS Revenue Procedure 2008-43. It says the IRS generally will view a rolling-average method used to value inventories for financial accounting purposes as clearly reflecting income, but that where inventory is held for several years or costs fluctuate substantially, such a method may or may not clearly reflect income. It deems the method to clearly reflect income if all of these hold:

- The rolling average is the one your books use to value inventory; the procedure warns that otherwise it may not clearly reflect income for tax.
- The average is recomputed each time you buy or produce more units of the item, or on a regular basis at least once a month.
- Either the variance between ending inventory at rolling-average cost and at FIFO or specific-identification cost, divided by the rolling-average cost, does not exceed one percent, or your entire inventory turns at least four times a year.

Whether your business has to keep inventories at all, including options for small businesses, is covered in a separate question.

## Must your books use the same method as your tax return?

Treasury regulation section 1.446-1 restates section 446(a): taxable income is computed under the method of accounting you regularly use in keeping your books. One method serving both is therefore the starting point.

LIFO makes that a condition. Section 472 allows LIFO only if, for the first LIFO year, you used no other inventory procedure to work out income, profit or loss in a report or statement to shareholders, partners or other proprietors, or beneficiaries, or for credit purposes. Section 472(e) carries the test forward: LIFO continues unless the IRS approves a change or determines that another procedure was used in a later year and requires a change. LIFO on the return means LIFO in the figures you give owners and lenders.

If your books and your return use different methods, which the LIFO rule limits, Treasury regulation section 1.446-1 lists a reconciliation of any differences between books and return among the accounting records a taxpayer keeps. Keep that reconciliation every year. Books that already disagree with a filed return are covered in a separate question.

## Do goods worth less than cost have to be carried lower?

That is a separate test, applied after the method has assigned cost. For U.S. GAAP statements, FASB's Accounting Standards Update 2015-11 requires inventory measured by any method other than LIFO or the retail inventory method (a separate valuation method Publication 538 also lists) to be carried at the lower of cost and net realizable value, defined as estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation. The update's examples are FIFO and average cost; specific identification is also covered. The update says the difference is recognized as a loss in earnings in the period in which it occurs, and it leaves LIFO and retail-method inventory on the existing lower-of-cost-or-market measurement.

For tax, IRS Publication 538 describes the lower of cost or market method: compare the market value of each item on hand on the inventory date with its cost and use the lower of the two, where market value for normal goods under ordinary circumstances is the usual bid price on that date. This is a choice, not a requirement: Revenue Procedure 2008-43 notes that Treasury regulation section 1.471-2(c) permits valuing inventory at either cost or the lower of cost or market, and Treasury regulation section 1.446-1 treats a later change of that basis as a change of method, which needs IRS consent. Publication 538 says the method does not apply to goods accounted for under LIFO, or to goods on hand or being manufactured for delivery at a fixed price on a firm sales contract; those must be inventoried at cost.

For GAAP statements, continuing the example, suppose the 12 units left can be sold for only 26.00 each, with 2.00 a unit to sell and deliver them. Their net realizable value is 288.00 (12 × 24.00). Under FIFO the 358.00 carrying amount comes down to 288.00, a 70.00 loss; under average cost, 300.00 comes down to 288.00, a 12.00 loss. On the return, Publication 538's market is that usual bid price, not net realizable value; a book write-down that the return does not take goes on your yearly reconciliation. Damaged, spoiled or unsaleable goods are covered in a separate question.

## What does consistency require from one period to the next?

IRS Publication 538 says your inventory practices must be consistent from year to year, and FASB Statement No. 154 says that once an accounting principle is adopted it shall be used consistently for similar events and transactions. The method and valuation basis you apply to your inventory therefore stay fixed. FASB issued Statement No. 154 in May 2005, and its Accounting Standards Update 2015-11 names the FASB Accounting Standards Codification as the source of authoritative GAAP, so confirm the current Codification text with your accountant before relying on Statement No. 154.

Some things may legitimately move:

- **Estimates.** FASB Statement No. 154 lists inventory obsolescence among the items that need estimates, and says a change in an estimate is not accounted for by restating or retrospectively adjusting prior periods.
- **Error corrections.** Treasury regulation section 1.446-1 says a change in method of accounting does not include correcting mathematical or posting errors.
- **Genuinely new kinds of transactions.** FASB Statement No. 154 says adopting a principle for events or transactions occurring for the first time, or for ones clearly different in substance from earlier ones, is not a change in accounting principle. New products like those you already sell are transactions of a similar type, for which it presumes no change; ask your accountant before putting a new line on a different method in the books or on the return.

Switching methods between years to lift the reported margin is none of these. It is a change of method: for tax, Treasury regulation section 1.446-1 requires IRS consent before income is computed under the new method, and for GAAP statements FASB Statement No. 154 requires a preferability justification, retrospective application and disclosure, as the next section sets out. The regulation requires that consent even between two permitted methods: it must be secured whether or not the new method is proper or permitted. Publication 538 warns that if you do not regularly use a method that clearly reflects income, your income will be refigured under the method that, in the IRS's opinion, does. Under Statement No. 154, a margin-driven GAAP switch that cannot be justified as preferable is not allowed.

## What does changing the method require?

**Choosing for the first time.** IRS Publication 538 says you choose an accounting method when you file your first tax return, and that if you later want to change it you must generally get IRS approval. If the first method is LIFO, the Form 970 goes with that return.

**Changing a method already used on returns.** For tax, take these steps in order:

1. Treat it as a change of method. Treasury regulation section 1.446-1 says a change in the overall plan or system of identifying or valuing items in inventory is a change in method of accounting, and that, except as otherwise expressly provided, a taxpayer who changes the method used in keeping its books must secure the IRS's consent before computing income under the new method for tax purposes.
2. Prepare Form 3115. IRS Publication 538 says that to change your method of accounting for inventory you must file Form 3115. If the new method is LIFO, Publication 538 also says to file Form 970, or a statement with its information, with your timely filed return for the year you first use LIFO; ask your preparer how that fits with Form 3115.
3. Use the right procedure. The IRS instructions for Form 3115 say that, unless published guidance provides otherwise, you must file under the automatic change procedures if you are eligible; no user fee is required, and an applicant that files timely and complies is granted consent, subject to review by the IRS National Office and operating division director. On that route, the instructions say to attach the original Form 3115 to your timely filed (including extensions) federal income tax return for the year of change and to file a signed copy with the IRS National Office no earlier than the first day of the year of change and no later than the date the original is filed. Otherwise, under the non-automatic procedures, the form is filed during the tax year for which the change is requested unless published guidance provides otherwise, a user fee is required, and approval comes as a letter ruling. The instructions refer to the IRS's list of automatic changes to show which route applies; follow their filing steps for that route.
4. Pick up earlier years through an adjustment in the year of change. The Form 3115 instructions define the year of change as the first tax year you use the new method and say a section 481(a) adjustment is ordinarily required. Section 481(a) of the Internal Revenue Code takes into account in that year the adjustments needed to prevent amounts from being duplicated or omitted. The Form 3115 instructions give the adjustment period as generally one tax year for a negative adjustment and four tax years, starting with the year of change, for a positive one (two years for a positive adjustment if the business is under IRS examination, subject to exceptions the instructions list; on a change to LIFO, section 472(d) takes the change from valuing opening inventory at cost into account ratably over three years, starting with the first LIFO year).

FASB's Accounting Standards Update 2015-11 gives an adjustment to an inventory balance to effect a change in inventory valuation method as an example of the direct effect of a change in accounting principle, so a switch of costing method in U.S. GAAP statements falls under FASB Statement No. 154, which sets these requirements:

- **Justification.** A change is allowed only if a newly issued accounting pronouncement requires it or you can justify the alternative as preferable.
- **Prior periods.** The change is reported through retrospective application to all prior periods unless that is impracticable, in which case Statement No. 154 sets fallbacks, down to applying the new method prospectively from the earliest date practicable.
- **Disclosure.** The statements disclose the nature of and reason for the change, including why the new method is preferable.

The record a change leaves is the Form 3115 as filed (plus a letter ruling on the non-automatic route), the section 481(a) computation, and in GAAP statements the recast figures and disclosure note. Add your own memo of the old method, the new one, the date and the reason.

## How do I find the method my system is already applying?

Many businesses never chose a method; the software applied one. Work through these steps in order:

1. Find the costing method setting in your accounting or inventory system and read that product's own help on it. If the system supports only one method, that is the method it applies to each sale; ask whoever closes your year whether any year-end entry changes the inventory figure in your statements.
2. If you use QuickBooks Online, Intuit's help article "Inventory valuation methods for cost accounting" (updated 8/14/2026) says you have two options, FIFO and Moving Average Cost; that if an inventory item is created before a method is chosen, QuickBooks Online defaults to FIFO and the option won't appear in account settings; and that the choice can't be changed later. The same page gives its average-cost calculation for Intuit Enterprise Suite, so confirm in your account settings, or with Intuit support, which method your plan applies before relying on this.
3. Find the method behind the closing inventory on your last filed return, from the preparer's workpapers or by asking the preparer.
4. Compare the two and write down what you found and where.

If the system's default differs from what the returns relied on, do not flip a setting to make them agree. Under Treasury regulation section 1.446-1, a change in how inventory is identified or valued is a change of method needing IRS consent, while correcting a mathematical or posting error is not; which of those describes an unexamined default depends on facts to settle with your tax preparer before the next return. Until then, keep the yearly reconciliation so the return's figure can be traced to the books.

## Which method fits your goods and your system?

Set the facts of your business against the permitted methods:

| If | Then |
|---|---|
| Each unit is identifiable, such as serial-numbered stock | Specific identification, with the record described below. |
| Units are interchangeable and mixed on the shelf | Choose among FIFO, average cost and LIFO; Publication 538 points to FIFO or LIFO when units cannot be matched to invoices, and an average on the return is covered by Revenue Procedure 2008-43 only if your books use the same rolling average. |
| You want LIFO for tax | Plan for Form 970 with the return for the first year you use LIFO, cost-only valuation and LIFO in reports to owners and lenders. |
| Your system offers one method, or locks the choice once items exist | Decide before creating items; the system applies its method to each sale, and section 446(a) computes taxable income under the method you keep your books on. Section 472 ties LIFO on the return to LIFO in reports to owners and lenders, and Revenue Procedure 2008-43 covers an average on the return only if the books use it; do not plan a different tax method without your preparer, and if one is used, keep the yearly reconciliation. |
| Lenders or owners compare periods | Choose once and keep it; any later switch brings consent, recast figures or disclosure. |

For serial-numbered equipment, vehicles or one-off pieces, specific identification is usually the realistic choice, because each unit can be matched to its own invoice, the condition Publication 538 sets. The record it needs is simple but must be complete: for every unit, its serial or stock number, the supplier invoice and the cost recorded when it arrived, with the unit shown as on hand until it sells and its own cost moves to cost of goods sold; the invoice and cost record then support that cost on your books and return.

## Sources

1. Internal Revenue Service — *Publication 538, Accounting Periods and Methods*, Publication 538 (01/2022). https://www.irs.gov/publications/p538
2. Internal Revenue Service — *Instructions for Form 3115, Application for Change in Accounting Method*, Revised 12/2022. https://www.irs.gov/instructions/i3115
3. Internal Revenue Service — *Rev. Proc. 2008-43*, effective for taxable years ending on or after December 31, 2007. https://www.irs.gov/pub/irs-drop/rp-08-43.pdf
4. Office of the Law Revision Counsel, U.S. House of Representatives (published on govinfo by the U.S. Government Publishing Office) — *26 U.S.C. 472, Last-in, first-out inventories*, United States Code, 2024 Edition. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleA-chap1-subchapE-partII-subpartD-sec472.htm
5. Office of the Law Revision Counsel, U.S. House of Representatives (published on govinfo by the U.S. Government Publishing Office) — *26 U.S.C. 481, Adjustments required by changes in method of accounting*, United States Code, 2024 Edition. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleA-chap1-subchapE-partIII-sec481.htm
6. Legal Information Institute, Cornell Law School — *26 CFR § 1.446-1, General rule for methods of accounting (Electronic Code of Federal Regulations text)*, undated. https://www.law.cornell.edu/cfr/text/26/1.446-1
7. Financial Accounting Standards Board — *Accounting Standards Update No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory*, July 2015. https://storage.fasb.org/ASU%202015-11.pdf
8. Financial Accounting Standards Board — *Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections*, May 2005. https://storage.fasb.org/fas154.pdf
9. Intuit Inc. — *Inventory valuation methods for cost accounting (QuickBooks Online help)*, Updated 8/14/2026. https://quickbooks.intuit.com/learn-support/en-us/help-article/inventory-management/fifo-used-inventory-cost-accounting/L1x3hkunE_US_en_US

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