Lesson 1 of 11
FIFO, LIFO, average
Three costings of the same shelf give three different profits. Caterpillar states about 70 percent of its inventories on a last-in, first-out basis.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Identical purchases and identical sales produce three different profits depending on which units are assumed to have been sold.
- The choice is an assumption about cost flow, not about physical movement. A LIFO company does not ship its newest stock first.
- LIFO is permitted in the United States and prohibited under international rules, so a US company and a foreign one are not comparable on gross margin without adjustment.
A company buys the same item three times at three prices, then sells some of them. Which cost goes to the income statement and which stays on the balance sheet?
There is no fact of the matter. The units are identical, and the answer is an assumption the company chooses and discloses.
One shelf, three costings
- Gross profit, first-in first-out$1,800
- Gross profit, weighted average$1,600
- Gross profit, last-in first-out$1,400
The arithmetic
Gross profit differs by $400, which is 29 percent of the lowest figure. The company bought the same goods, sold the same goods and banked the same cash.
Why the direction is predictable
When costs are rising, LIFO charges the newest and most expensive units to the income statement. That lowers reported profit and leaves the oldest and cheapest costs sitting in inventory on the balance sheet.
So a LIFO company in an inflationary period shows lower profit, lower inventory, a lower current ratio and a lower tax bill. The last of those is the reason the method exists: US tax law requires a company using LIFO for tax to use it in its financial statements as well.
When costs are falling the effects reverse, and in a period of stable costs the three methods converge.
What Caterpillar discloses
Caterpillar's fiscal 2025 10-K, filed on 13 February 2026, states in its accounting policies note that it determines cost principally using the last-in, first-out method, and that the value of inventories on the LIFO basis represented about 70 percent (Caterpillar Inc. FY2025 10-K, accession 0000018230-26-000008) of total inventories at 31 December 2025 and about 65 percent at 31 December 2024.
Two things follow from that sentence. The company is not entirely on LIFO, so any restatement onto a FIFO basis applies to part of the balance and not all of it. And the proportion moved five points in a year, so the mix itself changes.
Total inventories were $18,135 million (Caterpillar Inc. FY2025 10-K, accession 0000018230-26-000008) at 31 December 2025 and $16,827 million a year earlier.
The comparability problem
International accounting standards prohibit LIFO. A US industrial company using it and a European competitor using FIFO will report different gross margins for identical operations, and the gap widens as input costs rise.
This is not a small effect and it is not detectable from the income statement alone. The only way through it is the disclosure in the next lesson, which is the one number that lets the two be compared.
Check yourself
Costs are rising. Which method reports the highest gross profit?
- Last-in, first-out
- First-in, first-out
- They are identical by construction
Show the answer
Answer: B.
FIFO charges the oldest and cheapest units to cost of sales, leaving the newest and dearest in inventory. LIFO does the reverse and reports the lowest profit.What does a LIFO assumption say about how goods physically move?
- Newest stock is shipped first
- Nothing. It is an assumption about which costs flow to the income statement, not about physical movement
- Stock is never rotated
Show the answer
Answer: B.
Cost flow and physical flow are separate. A company can ship its oldest units and still cost them on a last-in, first-out basis.Caterpillar says LIFO covers about 70 percent of total inventories. Why does that matter?
- It means the disclosure is unreliable
- Any restatement onto a FIFO basis applies only to the LIFO portion, and the proportion itself changes year to year
- It means the company uses two sets of books
Show the answer
Answer: B.
A partial application means the reserve disclosed in the next lesson bridges part of the balance. The share moved from about 65 percent to about 70 percent in one year.Sources
- Caterpillar Inc., FY2025 Form 10-K, filed 13 February 2026, accession 0000018230-26-000008, accounting policies note, for the LIFO policy, the proportion of inventories on that basis at 31 December 2025 and 2024, and total inventories.
- ASC 330, Inventory, on cost flow assumptions and the measurement of inventory.
What this leaves out
- The three-method table uses invented round numbers so every figure can be checked by hand. It is not Caterpillar's arithmetic.
- The Caterpillar figures are history, read from the filing named. They are not a statement about the company today and not a view on any security.
- LIFO layers built up over decades can be liquidated in a year of falling volumes, which releases very old costs into profit. That effect is real, is disclosed when material, and is not covered here.
- Specific identification is a fourth method, used where units are individually tracked, and is not covered.