Home > Topics > Foundation – Paper 1 – Accounting > Inventory Valuation - Cost Methods
← PreviousNext →

Inventory Valuation - Cost Methods

"How you value inventory affects your profit!"

Inventory (Stock) is the goods held for sale in the ordinary course of business. Valuing inventory correctly is crucial because it directly impacts:

  • Cost of Goods Sold (COGS)
  • Gross Profit
  • Closing Stock in Balance Sheet

Why Inventory Valuation Matters

Formula:

Cost of Goods Sold = Opening Stock + Purchases - Closing Stock
Gross Profit = Sales - Cost of Goods Sold

If Closing Stock is overvalued → COGS decreases → Profit inflated
If Closing Stock is undervalued → COGS increases → Profit deflated

Methods of Inventory Valuation

Loading diagram…

1. FIFO (First In, First Out)

Assumption: Goods purchased first are sold first.

Logic: Like a queue—first person in line gets served first.

Example: FIFO

Transactions:

  • Jan 5: Purchased 100 units @ ₹10 each
  • Jan 15: Purchased 200 units @ ₹12 each
  • Jan 25: Sold 150 units

Cost of Goods Sold (FIFO):

  • First 100 units from Jan 5 purchase: 100 × ₹10 = ₹1,000
  • Next 50 units from Jan 15 purchase: 50 × ₹12 = ₹600
  • Total COGS = ₹1,600

Closing Stock:

  • Remaining 150 units (from Jan 15): 150 × ₹12 = ₹1,800

Advantages of FIFO

Loading note…

Disadvantages of FIFO

  • Higher Tax: In inflation, profit is overstated (old, cheaper goods sold).
  • Doesn't Reflect Current Costs: COGS based on old prices, not current replacement cost.

2. Weighted Average Cost Method

Assumption: All units are valued at the average cost of available inventory.

Formula:

Weighted Average Cost = Total Cost of Goods Available for Sale / Total Units Available

Example: Weighted Average

Same Data:

  • Jan 5: 100 units @ ₹10 = ₹1,000
  • Jan 15: 200 units @ ₹12 = ₹2,400
  • Total: 300 units costing ₹3,400

Weighted Average:

Average Cost = ₹3,400 ÷ 300 = ₹11.33 per unit

Cost of Goods Sold:

150 units × ₹11.33 = ₹1,700 (approx)

Closing Stock:

150 units × ₹11.33 = ₹1,700 (approx)

Advantages of Weighted Average

  • Smooths Fluctuations: No extreme highs/lows due to price changes.
  • Simple for Homogeneous Goods: Ideal for bulk commodities (wheat, coal, oil).
  • Acceptable under AS-2: Allowed by Indian Accounting Standards.

Disadvantages

  • Not Realistic: Doesn't match actual flow of goods.
  • Delayed Price Impact: Recent price changes take time to reflect.

3. Specific Identification Method

Assumption: Each item is individually identified and valued at its actual cost.

Example: Car dealership selling luxury cars—each car has a unique VIN and cost.

Advantages:

  • Most Accurate: Reflects actual cost of items sold.

Disadvantages:

  • Impractical: Only works for unique, high-value items (jewelry, real estate).

4. LIFO (Last In, First Out) - NOT Allowed in India

Assumption: Goods purchased last are sold first.

Status:

  • Not allowed under Indian Accounting Standards (AS-2)
  • Not allowed under Ind AS (IAS 2)
  • Allowed in USA under GAAP

Comparison: FIFO vs Weighted Average

Loading comparison…

Impact of Inflation

Scenario: Prices are rising (inflation)

MethodCOGSClosing StockProfit
FIFOLower (old prices)Higher (new prices)Higher
Weighted AvgModerateModerateModerate
LIFOHigher (new prices)Lower (old prices)Lower

Tax Implication: FIFO leads to higher profit → higher tax in inflationary times.

AS-2: Valuation of Inventories

Indian Accounting Standard AS-2 states:

Allowed Methods:

  • FIFO
  • Weighted Average
  • Specific Identification (for unique items)

NOT Allowed:

  • LIFO

Valuation Rule:
Inventory should be valued at Lower of Cost or Net Realizable Value (whichever is lower).

Real-World Example

Big Bazaar - FMCG Inventory

  • Products: Soaps, snacks, groceries
  • Method Used: FIFO (perishable goods must be sold in order)
  • Why? Ensures older stock (with earlier expiry dates) is sold first.

Quiz: Inventory Valuation

Loading quiz…

← PreviousNext →