Inventory valuation methods: FIFO vs weighted average.

The methods Indian standards allow.

Inventory valuation is how you put a rupee figure on the stock in your godown, and on the stock you sold. The two figures move together: what you call the cost of goods sold comes out of the stock, and whatever is not sold stays in it.

For goods that are interchangeable, like cartons of the same item bought at different rates, AS 2 and Ind AS 2 give you two cost formulas: first in, first out (FIFO) and weighted average. For goods that are not interchangeable, each item carries its own cost.

Standard cost and the retail method are shortcuts, not formulas of their own. You may use them only when the result comes close to actual cost.

One item, three answers.

Take a trader who starts April with 100 cartons bought at ₹500 each. The price goes up with every purchase. Every rate here is without the GST the trader claims back.

450 cartons are sold for ₹3,70,000 in all, and 300 are left on 30 April. Nothing about the goods changes between the three methods. Only the cost given to the cartons sold changes.

FIFO, step by step.

FIFO assumes the cartons that came in first go out first. Each sale takes from the oldest layer of stock until it runs out, then from the next.

The 12 April sale of 250 cartons takes all 100 opening cartons at ₹500 and 150 of the 5 April cartons at ₹550: ₹50,000 + ₹82,500 = ₹1,32,500.

The 24 April sale of 200 takes the last 50 cartons at ₹550 and 150 of the 18 April cartons at ₹600: ₹27,500 + ₹90,000 = ₹1,17,500.

Cost of goods sold is ₹2,50,000. The 300 cartons left are the latest ones: 150 at ₹600 and 150 at ₹640, so closing stock is ₹1,86,000.

FIFO gives the same answer whether you work it at each sale or once at the month end. That makes it easy to check by hand.

Weighted average: periodic or moving.

The weighted average spreads the cost of all the cartons over all the units. The standards allow it to be worked out for the whole period, or again each time a purchase comes in.

Periodic. Add the opening stock and every purchase: ₹4,36,000 for 750 cartons, or ₹581.33 a carton. All 450 cartons sold go out at that rate, so cost of goods sold is ₹2,61,600 and closing stock is ₹1,74,400. You only know the rate once the period is over.

Moving. After the 5 April purchase, 300 cartons cost ₹1,60,000: ₹533.33 each. The 12 April sale goes out at that rate, ₹1,33,333.33. After the 18 April purchase, 350 cartons are worth ₹2,06,666.67: ₹590.48 each, and the 24 April sale costs ₹1,18,095.24. After the last purchase, 300 cartons are worth ₹1,84,571.43, or ₹615.24 each.

Moving average cost of goods sold is ₹2,51,428.57. It lands close to FIFO here because each sale is costed with only the purchases made before it.

Moving average rates are rarely round figures. A stores ledger that rounds each rate can differ from software by a few paise.

What a price rise does to your margin.

Put the three results side by side. The sales are the same ₹3,70,000 in every column. The gross profit is not.

With prices rising, FIFO sends the older, cheaper cartons into cost of goods sold and keeps the dearer ones in stock. So it shows the highest closing stock and the highest profit. The periodic average mixes the dear 28 April cartons into every sale, even the sale on 12 April, so it shows the lowest profit.

The gap between FIFO and the periodic average is ₹11,600 on one item in one month. Across hundreds of items and a year of rising prices, the difference in reported profit, and in the stock figure your bank sees, can be large.

When prices fall, it turns round: FIFO shows the lower profit. And over the life of the stock the total cost is the same. The method changes when profit is reported, not how much.

Why LIFO is not allowed.

Last in, first out (LIFO) sends the newest, dearest units into cost first. In a price rise it shows lower profit and leaves old, cheap rates in the stock figure, sometimes for years.

Indian accounting standards leave it out. AS 2 and Ind AS 2 name only FIFO and weighted average for interchangeable goods, and ICDS II, used to work out taxable income, says the same. You will still see LIFO in textbooks and in some older software, but not in Indian accounts.

What goes into cost.

Before any formula, decide what a unit costs. AS 2 counts every cost of bringing the goods to where they are and the state they are in. Anything after that is an expense of the period, not stock.

• In: the purchase price, after trade discounts and rebates.
• In: freight inwards, loading, unloading and other costs of getting the goods to your godown.
• In: duties and taxes you can’t claim back, such as customs duty on imports.
• In, for goods you make: conversion costs, meaning direct labour and production overheads, spread on normal capacity.
• Out: GST you claim as input tax credit.
• Out: interest on the money you borrowed to buy the stock, in the usual case.
• Out: storage after the goods are ready, office overheads, and selling and delivery costs.
• Out: abnormal waste.

GST credit is not stock cost.

This is where many stock figures go wrong. A regular GST-registered trader pays GST on a purchase and takes it back as input tax credit. That GST is recovered, so it sits in the electronic credit ledger, not in the godown.

Say the 5 April purchase carried GST at 18%: ₹99 on each ₹550 carton, ₹19,800 in all. A regular dealer who claims the credit still values each carton at ₹550.

A dealer under the composition scheme can’t claim input tax credit. For that dealer, the ₹99 is part of what the carton cost, so each carton is ₹649. The same applies to any GST you can’t claim back, such as blocked credit: it becomes part of cost.

So enter purchase rates without the GST you get back, and with any GST you don’t. Whether a particular credit is available is a GST question for your CA.

Lower of cost and NRV, and the write-down.

Cost is not the end of it. Stock is shown at its cost or its net realisable value (NRV), whichever is lower. NRV is what you expect to sell it for, less the costs to finish and sell it.

Say that on 30 April a new model pushes the selling price of these cartons down to ₹600, and it costs ₹20 a carton to sell them. NRV is ₹580 a carton, or ₹1,74,000 for the 300 left.

By FIFO the stock cost ₹1,86,000, so it is written down by ₹12,000. By the moving average the write-down is ₹10,571.43, and by the periodic average only ₹400. The write-down is an expense of the month, and it narrows the gap between the methods.

Compare item by item, not on the whole godown. A profit on one item does not hide a loss on another. Under Ind AS 2, if the price recovers while the stock is still on hand, the write-down is reversed, up to the amount written down.

Sticking to a method, or changing it.

Pick one formula for all stock of a similar nature and use, and keep it. Different formulas are allowed only for stock that is genuinely different in nature or use. A second warehouse in another state is not a reason on its own.

Your accounts state the cost formula you use. A change of method is a change in accounting policy: it needs a good reason, and its effect must be disclosed, because it makes this year’s profit hard to compare with last year’s.

For income tax, ICDS II says a method once adopted is not changed without reasonable cause. Talk to your auditor before you switch.

Income tax and ICDS II.

ICDS II is the income tax standard on valuing inventories. It follows AS 2 closely: lower of cost and NRV, FIFO or weighted average, no LIFO.

The big difference is taxes. AS 2 leaves out the taxes you recover, the “exclusive method”. ICDS II counts taxes and duties in the cost, the “inclusive method”. ICAI’s technical guide explains that the adjustment for this is usually tax neutral, and that a memorandum working shows it.

So the stock figure in your books and the one in your tax working can differ. Your tax adviser makes that adjustment; it does not change the method you choose.

How to choose.

Both FIFO and weighted average are allowed, so choose the one that best matches how your goods actually move and that your team can keep up. These questions help.

This guide is general information, not accounting or tax advice. Confirm the method for your books with your CA.

• Do the goods physically go out oldest first, because they expire, go out of fashion or carry batch dates? FIFO matches that.
• Are the goods mixed in one bin, like grain, oil, cement or loose hardware? A weighted average fits better.
• Do you need cost and margin on each sale, the day it happens? Use FIFO or the moving average, kept by software.
• Do you only value stock at month or year end? The periodic average is simple and allowed.
• Are some items one-offs, or bought for one job? Cost those by specific identification.
• Will you keep the same method next year? If not, don’t switch without your auditor.

What an ERP does for you.

By hand or in a spreadsheet, the periodic average is the easiest to work out, and only at the period end. A moving average, or FIFO layer by layer across hundreds of items, is a job for software.

An ERP values stock as it moves. In PrimoERP, every receipt and issue carries a value as well as a quantity, at FIFO, weighted average or standard cost, chosen for each item category. Choose before your first stock movement: once stock has moved, the method stays, so past values never change.

Each movement posts to your accounts by itself, and at month end the stock value is checked against the ledger before the month can close. Because every sale carries what the goods cost you, margin by item, customer or branch is a report, not a calculation.

To try the numbers on your own item first, use our free stock valuation calculator: it shows FIFO and both averages side by side, with the working.