What it means
When a business buys or makes the same item at different prices over time, it needs a rule for deciding which cost belongs to the units sold and which to the units still on the shelf. That rule is the valuation method.
Three are widely used: first in, first out (FIFO), weighted average cost, and last in, first out (LIFO). FIFO assumes the oldest units are sold first, so the ending inventory is valued at the most recent costs.
Weighted average cost blends all the purchase costs into one average figure per unit. LIFO assumes the newest units are sold first, which leaves the oldest costs on the balance sheet.
The choice matters most when prices are changing. In a period of rising prices FIFO reports a lower cost of goods sold and a higher profit than the other methods, while LIFO does the opposite and can reduce a tax bill in jurisdictions that allow it.
Under IFRS (International Financial Reporting Standards) LIFO is not permitted, whereas US accounting rules do allow it. Whatever the method, inventory must not be carried above what it can realistically be recovered for.
Accounting rules require stock to be written down if its net realisable value (the expected selling price less the costs to complete and sell) falls below cost. This protects readers of the accounts from a balance sheet that overstates what the goods are worth.
A business should apply its chosen method consistently from year to year, and any change has to be disclosed and justified. Switching methods just to improve a profit figure is a red flag for auditors and lenders alike.
In practice
Real-world examples
Example 1
A furniture importer buys containers of sofas at rising prices through the year. It uses FIFO, so its closing stock reflects the most recent, higher costs. The balance sheet looks stronger, and the finance director reminds the board that part of the extra profit is simply price inflation.
Example 2
A chemicals distributor holds interchangeable bulk liquids in a tank. It uses weighted average cost because the units are indistinguishable and every delivery is mixed together. The system recalculates the average cost each time a new delivery arrives.
Example 3
A US steel service centre uses LIFO to match its newest, highest steel costs against current sales. Its reported profit is lower in a rising price year, and so is its taxable income. Its finance team also reports an adjustment, sometimes called the LIFO reserve, so lenders can see what the stock would be worth under FIFO.
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
Ending inventory = Cost of goods available for sale - Cost of goods sold
Cost of goods available for sale = Opening inventory cost + Purchases
A shop starts the month with 100 units costing $10 each ($1,000) and buys 100 more at $14 each ($1,400), so 200 units costing 1,000 + 1,400 = $2,400 are available. It sells 120 units. Under FIFO the cost of goods sold is 100 x 10 + 20 x 14 = 1,000 + 280 = $1,280, so ending inventory is 2,400 - 1,280 = $1,120. Under weighted average the unit cost is 2,400 / 200 = $12, so cost of goods sold is 120 x 12 = $1,440 and ending inventory is 2,400 - 1,440 = $960. FIFO therefore reports $160 more profit than weighted average.Case study
Seen in the real world
Coldharbour Outdoor Gear is an illustrative, fictional retailer of camping equipment. Its purchasing costs for tents rose steadily over two years, and the finance controller noticed that gross margin looked healthy even though the company had not raised prices. The cause was FIFO: older, cheaper tent costs were flowing through cost of goods sold while the shelves filled with more expensive stock.
The controller built a simple schedule showing what profit would have been under weighted average cost. The gap was about $85,000 across the year, which the board agreed was a timing effect rather than real improvement. They kept FIFO but added a note to the management accounts so that nobody planned spending against margin that would disappear when the cheap stock ran out.
Watch out
Common mistakes
- Assuming the valuation method has to match the physical order in which goods are moved, when it is an accounting assumption about cost flow.
- Comparing the profits of two companies without checking whether they use different valuation methods.
- Forgetting to write stock down when its selling price falls below cost, which leaves the balance sheet overstated.
Questions
People also ask
Which valuation method gives the highest profit?
In a period of rising prices FIFO normally reports the highest profit, and in a period of falling prices LIFO normally does.
Can a company change its inventory valuation method?
Yes, but it must show the change is justified, apply it consistently afterwards and disclose the effect on the accounts.
Does the method change the actual cash the business holds?
No, cash is unaffected, although a method that lowers taxable profit can reduce the tax paid.
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