Highest In, First Out (HIFO)

Key takeaways

• HIFO is an inventory accounting approach that removes the highest-cost items from inventory first, producing the largest possible cost of goods sold (COGS) and the lowest ending inventory value for a period.
• Because it increases COGS, HIFO can reduce taxable income in the short term.
• HIFO is rarely used and is not recognized by GAAP or IFRS for external financial reporting, so its use can raise audit and lending issues.

What HIFO means

Highest In, First Out (HIFO) records the costliest units in inventory as the first ones sold or used. When applying HIFO, a company assigns the highest available purchase cost to COGS before lower-cost units, regardless of purchase date. That pushes up COGS and lowers reported ending inventory.

How HIFO contrasts with LIFO and FIFO

• FIFO (First In, First Out): oldest inventory costs are recorded as COGS first; ending inventory reflects recent costs.
• LIFO (Last In, First Out): most recently purchased costs are charged to COGS first; LIFO is an accepted method under GAAP in some jurisdictions.
• HIFO: selects the highest-cost items for COGS first, without regard to purchase order. HIFO is not generally accepted under standard accounting frameworks.

Simple example

Inventory purchases:
* 1 unit at $10
1 unit at $12
1 unit at $15

If you sell one unit:
* FIFO COGS = $10
LIFO COGS = $15 (if last purchased is assumed sold)
HIFO COGS = $15 (highest cost taken first)

With HIFO, COGS is maximized ($15) and ending inventory value minimized ($10 + $12 = $22).

Practical implications and risks

• Tax and earnings: Higher COGS reduces taxable income and reported profits for the period.
• Audit and reporting: Because HIFO is not recognized by GAAP/IFRS, financial statements using it can face increased auditor scrutiny and potentially adverse audit opinions.
• Operational and valuation effects: Lower reported inventory reduces net working capital and may weaken borrowing capacity for asset-based loans.
• Obsolescence risk: In inflationary environments, treating high-cost items as sold first may leave older, lower-cost units on the books that could become obsolete or harder to sell.
• Rarity of use: HIFO is uncommon in practice and typically not used for external financial reporting.

When HIFO might be used

Companies may consider HIFO for internal inventory tracking or tax planning in jurisdictions where permitted, often to smooth earnings or manage taxable income. However, because it lacks acceptance under major accounting standards and carries financial-statement and lending consequences, its use is limited and should be evaluated with accounting and tax advisors.

Conclusion

HIFO prioritizes the highest-cost inventory items for COGS, maximizing expense and minimizing ending inventory. While it can lower taxable income in the short term, HIFO’s lack of recognition by standard accounting frameworks, potential audit issues, and impacts on working capital and lending make it an uncommon choice for formal financial reporting.