What it means
When a business buys or makes the same item at different costs over time, the question of which cost attaches to the items sold and which to the items still in stock has no single answer. The methods are conventions.
FIFO assumes the oldest items go first, so closing stock carries the most recent costs. Weighted average blends all costs into one figure.
LIFO assumes the newest items go first, leaving closing stock at old costs. Specific identification, which tracks the actual cost of each item, is used for high-value, distinguishable goods such as cars, jewellery and property.
In a period of stable prices the methods give the same result; when prices move, they diverge, and FIFO reports the highest profit during inflation while LIFO reports the lowest. Cost itself must be defined.
For purchased goods it includes the purchase price, import duties, freight and handling, less trade discounts. For manufactured goods it includes materials, direct labour and a systematic share of production overhead (absorption costing), but not selling costs, storage of finished goods or abnormal waste.
Getting the overhead absorption right is a substantial part of inventory accounting in a manufacturer. The second half of the rule, net realisable value, protects against overstatement.
If stock can no longer be sold for more than it cost, because it is damaged, obsolete, out of fashion or simply overpriced, it must be written down to the estimated selling price less the costs of completion and sale. Write-downs are charged to cost of sales in the period they are identified.
Reviewing stock for slow-moving and obsolete items is a routine part of the period-end close and a standard audit test. Inventory valuation is a frequent source of error and manipulation because it involves counting, costing and judgement.
Overstating closing inventory understates cost of sales and overstates profit; the error reverses the following year when the overstated opening stock flows through. Auditors attend stock counts, test costing and challenge net realisable value assessments for that reason.
In practice
Real-world examples.
Example
A supermarket values its stock on weighted average cost using its scanning system, and reviews fresh produce daily for write-downs.
Example
A car dealer uses specific identification, carrying each vehicle at its actual invoice cost until sold.
Example
A fashion retailer writes down last season's stock to 40% of cost at each period end based on historical clearance prices, and discloses the write-down in its accounts.
Think of it
“Inventory valuation is like deciding which concert tickets to sell first-the old cheap ones or the new expensive ones. Your choice affects reported profit.
Formula
Calculation
Cost of Goods Sold = Opening Inventory + Purchases (or Production Cost) minus Closing Inventory
Inventory carrying value = Lower of Cost and Net Realisable Value
Net Realisable Value = Estimated Selling Price minus Estimated Costs to Complete and Sell
Worked example. A hardware retailer's stock of a power drill over a quarter:
- Opening stock: 40 units at $50 = $2,000
- Purchase in month 1: 60 units at $55 = $3,300
- Purchase in month 2: 50 units at $60 = $3,000
- Sales during the quarter: 120 units at $95 = $11,400
- Closing stock: 30 units
FIFO: the 120 sold are 40 at $50, 60 at $55 and 20 at $60. COGS = $2,000 + $3,300 + $1,200 = $6,500. Closing stock = 30 at $60 = $1,800. Gross profit = $4,900.
Weighted average: total cost $8,300 for 150 units = $55.33 each. COGS = 120 x $55.33 = $6,640. Closing stock = 30 x $55.33 = $1,660. Gross profit = $4,760.
LIFO (US GAAP only): the 120 sold are 50 at $60, 60 at $55 and 10 at $50. COGS = $3,000 + $3,300 + $500 = $6,800. Closing stock = 30 at $50 = $1,500. Gross profit = $4,600.
Net realisable value test: the drill is superseded by a new model and the retailer expects to clear the remaining 30 units at $52 each, with $2 per unit of selling cost. NRV = $50 per unit = $1,500. Under FIFO, closing stock of $1,800 must be written down by $300 to $1,500; under weighted average, by $160. Under LIFO, cost of $1,500 already equals NRV.Case study
Seen in the real world.
An electronics distributor reported record profits for two years while its warehouse filled with stock. The year-end inventory figure was taken from the warehouse system without a full count or a review for obsolescence. When a new auditor insisted on a physical count and an ageing analysis, the picture changed.
Counted stock was $900,000 below the system figure, the result of unrecorded returns and theft. A further $1.4 million of stock consisted of superseded models with a resale value of a fifth of cost. The combined adjustment of $2.0 million turned the year's profit of $1.5 million into a loss, restated the prior year, and breached the bank's covenants.
The distributor introduced cycle counting, a monthly ageing report with automatic write-down rules by age band, and purchasing limits tied to sell-through rates. The finance director's reflection was that the profit had never existed; the inventory valuation had simply delayed the moment of discovering it.
Watch out
Common mistakes.
- Valuing stock at cost without testing net realisable value. Obsolete stock at full cost overstates both assets and profit.
- Including selling costs, storage of finished goods or abnormal waste in inventory cost. Only costs of bringing stock to its present location and condition belong.
- Changing methods between years to manage profit. Standards require consistency and disclosure.
Questions
People also ask.
Which inventory method is best?
FIFO and weighted average are both acceptable under IFRS and US GAAP; the choice should reflect the business and be applied consistently. LIFO is US-only and mainly tax-driven.
How does inventory valuation affect profit?
Closing inventory is deducted in arriving at cost of goods sold, so a higher closing valuation means lower COGS and higher profit in the current period, and the reverse next period.
What is net realisable value?
The estimated selling price in the ordinary course of business less the costs to complete and sell. Inventory is written down to it when it falls below cost.
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