First of all FIFO stands for: first in, first out. LIFO means: last in, first out.
The FIFO method assumes that sales are made from the items that have been longest in the inventory. This conforms to the usual business practice of trying to sell the older items first, before they become obsolete, spoiled, or out-of-fashion. The LIFO method assumes that the most recently purchased items are the ones you sold, and the oldest items are still sitting in your warehouse or on your shelf.
Now that you know what the acronyms mean you probably want to know why you would use either of them:
The IRS isn't very fond of LIFO. Fear of upsetting the IRS should be reason enough not to use this inventory method. The reason the IRS frowns on using the LIFO method is that it shows lower profits during periods of rising prices. Lower profits of course mean les tax for your small business. The IRS goes so far to discourage this accounting practice that they require you to ask permission via Form 970.
If the prices of your product are generally going up, LIFO will match your gross income against the most expensive items in your inventory, resulting in lower net profits and a lower tax bill. If your business and inventory are constantly growing then LIFO is a strong advantage if you don't mind dark clouds hovering over your small business, constantly threatening to rain down audits and tax inspectors.
If you've just started your small business and don't use LIFO to value your inventory, you may select the lower-of-cost-or-market method of inventory accounting. If you do choose this small business accounting method, you need to use it value your entire inventory. Once you use this accounting method you can't change to another method without the IRS's consent. Typically, the IRS is most concerned with year to year consistency. Inventory methods that accurately reflect your income should raise few alarms regardless of which method you use.
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