Inventory Valuation Methods: FIFO, Weighted Average, and Specific Identification

Ramesh’s Inventory Puzzle

Ramesh runs an electronics store. In March, he bought:

• 100 phones @ ₹10,000 each on March 5
• 100 phones @ ₹12,000 each on March 20

By March 31, he sold 120 phones at ₹15,000 each.

His accountant asked: “Which phones did you sell—the ₹10,000 ones or the ₹12,000 ones?”

Ramesh was puzzled. “They’re all the same model. Does it matter?”

It matters a lot.

If he sold the ₹10,000 phones: Cost = ₹12 lakh, Profit = ₹6 lakh If he sold the ₹12,000 phones: Cost = ₹14.4 lakh, Profit = ₹3.6 lakh

Same sales, different profits. That’s the power of inventory valuation.

Why Inventory Valuation Matters

Impact on Financial Statements

The Basic Formula

Opening Inventory + Purchases - Closing Inventory = Cost of Goods Sold

Therefore:
Higher Closing Inventory = Lower COGS = Higher Profit
Lower Closing Inventory = Higher COGS = Lower Profit

Inventory Valuation Principle

Lower of Cost or Net Realizable Value (NRV)

As per Ind AS 2 / AS 2:

Inventory Value = Lower of (Cost, NRV)

Example: NRV Application

Product B must be written down to ₹80.

Cost Flow Assumptions

When identical items are purchased at different prices, we need a method to determine which cost flows to COGS and which remains in inventory.

Methods Allowed (Ind AS 2 / AS 2)

LIFO Not Allowed

LIFO (Last In, First Out) is explicitly prohibited under:

• Ind AS 2
• AS 2
• IFRS

FIFO (First In, First Out)

Concept

Items purchased first are assumed to be sold first. Closing inventory consists of most recent purchases.

Characteristics

Example: FIFO Method

Transactions:

FIFO Calculation:

Sale on March 15 (150 units):

• 100 units @ ₹10 = ₹1,000 (from opening)
• 50 units @ ₹12 = ₹600 (from Mar 10 purchase)
• Total COGS = ₹1,600

Stock after March 15: 150 units @ ₹12 = ₹1,800

Sale on March 25 (200 units):

• 150 units @ ₹12 = ₹1,800 (remaining from Mar 10)
• 50 units @ ₹14 = ₹700 (from Mar 20 purchase)
• Total COGS = ₹2,500

Closing Stock: 100 units @ ₹14 = ₹1,400

Summary:

Weighted Average Method

Concept

Calculate average cost of all units available for sale. Use this average for both COGS and closing inventory.

Types

Periodic Weighted Average Example

Same transactions as FIFO example:

Weighted Average Cost:

₹5,500 / 450 units = ₹12.22 per unit

Calculation:

Moving Weighted Average Example

Stock Ledger with Moving Average:

*Average after Mar 10: (1,000 + 2,400) / 300 = ₹11.33 **Average after Mar 20: (1,700 + 2,100) / 300 = ₹12.67

Closing Stock: 100 units @ ₹12.67 = ₹1,267 COGS: ₹5,500 - ₹1,267 = ₹4,233

Specific Identification Method

Concept

Track actual cost of each specific item. Used for unique, high-value items.

When to Use

Example

Car Dealer:

Comparison of Methods

Same Data, Different Results

Using our example (450 units purchased, 350 sold):

Impact in Rising Prices

Impact in Falling Prices

Which Method to Choose?

Factors to Consider

Industry Practices

Accounting Entries

Purchase Entry

Purchases A/c (or Inventory A/c)    Dr.    50,000
Input GST A/c                       Dr.     9,000
    To Supplier A/c                              59,000
(Being goods purchased)

Sale Entry

Customer A/c                        Dr.    70,800
    To Sales A/c                                 60,000
    To Output GST A/c                            10,800
(Being goods sold)

Cost of Goods Sold Entry (Perpetual System)

Cost of Goods Sold A/c              Dr.    40,000
    To Inventory A/c                             40,000
(Being COGS recorded)

Closing Stock Entry (Periodic System)

Closing Stock A/c                   Dr.    15,000
    To Trading A/c                               15,000
(Being closing stock transferred)

Write-down Entry

Loss on Inventory Write-down A/c    Dr.     5,000
    To Inventory A/c                              5,000
(Being inventory written down to NRV)

Perpetual vs Periodic Inventory System

Comparison

Perpetual System Example

Stock Ledger Card:

*New average: (1,000 + 600) / 150 = ₹10.67 **New average: (747 + 1,150) / 170 = ₹11.16

Special Inventory Situations

Joint Products

Products from same process with significant value.

Example: Crude oil → Petrol, Diesel, LPG

Cost Allocation Methods:

• Physical quantity method
• Sales value method
• Net realizable value method

By-Products

Products from same process with minor value.

Treatment: Credit by-product NRV to main product cost.

Scrap

Material with minimal value.

Treatment: Credit scrap value when sold.

Work-in-Progress (WIP)

Partially completed goods.

Valuation: Include proportionate conversion costs.

Inventory Disclosures

Required Disclosures (Ind AS 2)

Example Disclosure

Note X: Inventories

Inventories are valued at lower of cost and net realizable value. Cost is determined using weighted average method.

Common Mistakes in Inventory Valuation

Mistake 1: Inconsistent Method

Error: Switching between FIFO and Weighted Average Impact: Non-comparable financials Solution: Use consistent method; disclose changes

Mistake 2: Ignoring NRV

Error: Not writing down slow-moving inventory Impact: Overstated inventory and profit Solution: Regular NRV assessment

Mistake 3: Excluding Costs

Error: Not including freight, duties in cost Impact: Understated inventory Solution: Include all costs to bring inventory to present location

Mistake 4: Including Non-Inventoriable Costs

Error: Including abnormal waste, storage costs Impact: Overstated inventory Solution: Expense such costs immediately

Mistake 5: Poor Cut-off

Error: Including goods in transit not owned Impact: Misstated inventory Solution: Verify ownership at cut-off date

Inventory Management Ratios

Key Ratios

Example Analysis

Interpretation: Inventory is moving slower; possible obsolescence risk.

Practical Tips

For Traders

• Use FIFO for perishables
• Conduct quarterly NRV reviews
• Track slow-moving items separately
• Implement proper cut-off procedures

For Manufacturers

• Segregate raw materials, WIP, finished goods
• Apply consistent overhead allocation
• Review WIP valuation quarterly
• Document cost allocation basis

For Auditors

• Test physical count accuracy
• Verify NRV calculations
• Check cut-off procedures
• Review cost build-up
• Confirm pledged inventory

Disclaimer

This guide is for educational purposes. Inventory valuation depends on specific business circumstances and applicable accounting standards (Ind AS / IGAAP). Consult a qualified Chartered Accountant for compliance matters.

Summary

Key inventory valuation principles:

1. Valuation Rule: Lower of Cost or NRV
2. FIFO: First items purchased are first sold
3. Weighted Average: Average cost of all units
4. Specific Identification: Actual cost of specific items
5. LIFO: Not allowed in India
6. Consistency: Use same method consistently
7. Disclosure: Transparent reporting of policies

Remember: The method chosen impacts profit, tax, and balance sheet values. Choose wisely and apply consistently.

Social Media Posts

LinkedIn: “Same inventory. Same sales. Different profits.

Ramesh sold 120 phones for ₹18 lakhs. His profit? • FIFO method: ₹6 lakhs • Weighted Average: ₹5.5 lakhs

Nothing changed in the business. Only the accounting assumption.

Key points: • FIFO: Older costs flow to COGS first • Weighted Average: Smoothed cost • LIFO: Not allowed in India

In rising prices, FIFO shows higher profit (and higher tax).

Choose your inventory method wisely. #InventoryAccounting #Finance”

Twitter/X: “Inventory Valuation 101:

FIFO: First bought = First sold Weighted Avg: Average of all purchases Specific ID: Actual cost per item

LIFO: ❌ Not allowed in India

Rising prices: FIFO → Lower COGS → Higher profit → Higher tax

Always value at: Lower of Cost or NRV

#AccountingBasics”

Instagram: “Why do accountants argue about inventory? 🤔

THE PUZZLE: Bought phones at ₹10K and ₹12K Sold some phones Which ones did we sell?

METHOD 1 - FIFO: Old ones first → Lower COGS → Higher profit

METHOD 2 - Weighted Average: Average cost → Medium profit

SAME GOODS. DIFFERENT PROFIT. 📊

Why it matters: • Higher profit = Higher tax 💸 • Lower inventory = Lower assets 📉

Pro tip: Be consistent. Don’t switch methods!

#InventoryValuation #AccountingTips”