Lesson 21 of 33 · Free
Contents
- 1 Inventory & Cost of Goods Sold
- 1.1 Why inventory is the trickiest current asset
- 1.2 Three categories of inventory
- 1.3 The cost of goods sold formula
- 1.4 Three costing methods
- 1.5 Worked example — see the difference
- 1.6 Lower of Cost or NRV
- 1.7 Perpetual vs periodic
- 1.8 Inventory KPIs
- 1.9 Lesson recap
- 1.10 Practical Indian Application
- 1.11 Worked Example — Universal Hardware Inventory Calculation
- 1.12 Common Inventory Mistakes
- 1.13 Frequently Asked Questions
- 1.14 Inventory Analytics
Inventory & Cost of Goods Sold
Three categories, three costing methods, one COGS formula. FIFO vs LIFO vs Weighted Average — and why LIFO is banned under IFRS.
Why inventory is the trickiest current asset
Cash is cash — its value is unambiguous. Receivables get written down if uncollectible. But inventory? You bought 1,000 units at varying prices over the year. Which unit did you sell first? At what cost should the unsold pile be valued? The answer affects gross profit, taxable income, and the balance sheet — and there are three accepted methods, each producing a different number.
Three categories of inventory
- Raw materials — inputs not yet started in production.
- Work in progress (WIP) — partially completed goods.
- Finished goods — ready for sale.
A pure trading business holds only finished goods. A manufacturer holds all three. A SaaS business holds none — services have no inventory.
The cost of goods sold formula
If opening inventory is ₹2 lakh, purchases during the year are ₹15 lakh, and closing inventory is ₹3 lakh, then COGS = 2 + 15 − 3 = ₹14 lakh. The challenge is figuring out the “₹3 lakh closing” number — which depends on which costing method you use.
Three costing methods
FIFO — First In, First Out
The oldest units are assumed to be sold first. Closing inventory is valued at the most recent purchase prices. In a rising-price environment: lower COGS, higher profit, higher inventory on the balance sheet.
LIFO — Last In, First Out
The newest units are assumed to be sold first. Closing inventory is valued at the oldest prices. In a rising-price environment: higher COGS, lower profit (and lower tax), lower inventory on the balance sheet. LIFO is banned under IFRS and Ind AS; it remains legal under US GAAP.
Weighted Average Cost (WAC)
All units are priced at the average cost of all units available. Smooths price volatility. The most common method used in India.
Worked example — see the difference
Purchases during the year:
| Date | Units | Price/unit | Total cost |
|---|---|---|---|
| Jan | 100 | 100 | 10,000 |
| Apr | 100 | 110 | 11,000 |
| Aug | 100 | 120 | 12,000 |
| Nov | 100 | 130 | 13,000 |
| Total | 400 | 46,000 |
Sales: 250 units. Closing inventory: 150 units.
| Method | Closing inventory | COGS |
|---|---|---|
| FIFO | 19,000 (100×130 + 50×120) | 27,000 |
| LIFO | 15,500 (100×100 + 50×110) | 30,500 |
| WAC | 17,250 (150 × 115) | 28,750 |
Same business, same transactions — but ₹3,500 of difference in profit just from the method chosen.
Lower of Cost or NRV
Conservatism rule: inventory is valued at the LOWER of cost or net realisable value (NRV). If you bought stock at ₹100/unit but the market price has dropped to ₹80, you must write it down. The journal entry:
Dr. Inventory Write-down Expense (P&L)
Cr. Inventory
Once written down, you don’t write up later under most frameworks — even if market prices recover.
Perpetual vs periodic
- Perpetual — inventory account updated after every transaction. Modern POS and ERP systems work this way. Real-time stock visibility.
- Periodic — inventory account updated only at period-end via physical count. Simpler but blind between counts. Used in micro-businesses without barcoded inventory.
Inventory KPIs
- Inventory turnover = COGS ÷ Average inventory. Times per year stock cycles.
- Days inventory outstanding = 365 ÷ Inventory turnover.
- Obsolete inventory % — slow-moving stock as % of total.
- Stock-out frequency — % of SKUs that hit zero unexpectedly.
Lesson recap
- Three categories: raw materials, WIP, finished goods.
- COGS = Opening + Purchases − Closing.
- FIFO, LIFO, WAC produce different numbers; LIFO is banned under IFRS / Ind AS.
- Lower of cost or NRV — write down if market drops.
- Perpetual systems are the modern standard.
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Practical Indian Application
Reference materials: AS 2 / Ind AS 2 for inventory valuation methodology; Cost Accounting Records Rules 2014 (Section 148 of Companies Act); Tally Prime Stock Summary; ICAI Guidance Note on Inventory Valuation; sectoral best-in-class inventory days benchmarks via CRISIL/ICRA.
Worked Example — Universal Hardware Inventory Calculation
Imagine Universal Hardware, Ludhiana, has opening stock ₹15,00,000, purchases ₹85,00,000, freight inwards ₹2,00,000, closing stock (physically verified) ₹12,00,000. COGS = 15+85+2−12 = ₹90,00,000. If revenue is ₹1,20,00,000, Gross Profit = ₹30,00,000 and GP margin = 25%. During the year-end physical count, the team identifies ₹50,000 of damaged items whose realisable value is only ₹10,000 — a write-down of ₹40,000 is posted: Dr Inventory Write-down ₹40,000, Cr Inventory ₹40,000. The auditor verifies the physical count, traces a sample of cost vouchers, and checks the lower-of-cost-or-NRV computation before signing off.
Common Inventory Mistakes
- Including non-recoverable GST in inventory cost
- Using LIFO method (prohibited under both AS 2 and Ind AS 2)
- Skipping physical verification at year-end
- Not writing down slow-moving or obsolete inventory to NRV
Frequently Asked Questions
Is LIFO allowed under Ind AS?
No. Only FIFO or Weighted Average. AS 2 also disallows LIFO since the 2011 revision.
Should GST be included in inventory cost?
No, when ITC is available. GST should be recorded as Input Tax Credit (an asset) separately. When ITC is not available (e.g., blocked credit), it forms part of cost.
How are samples and free goods accounted?
Free samples are an advertisement expense; goods given as discount (buy 10 get 1 free) reduce average selling price.
Inventory Analytics
Beyond basic FIFO and Weighted Average, modern inventory analytics use ABC classification (high-value SKUs need tight control), XYZ classification (high-volatility SKUs need buffer stock), and FSN analysis (fast/slow/non-moving). Indian retailers like DMart and Vishal Mega Mart use predictive demand models to keep inventory days below 30 — a key reason their working-capital cycle is negative. Pharma firms maintain batch-wise expiry tracking with auto-alerts at 90, 60 and 30 days before expiry. A company holding ₹40 lakh inventory with 60% fast-moving (turns 8x), 30% slow-moving (turns 2x), 10% non-moving (turns 0.5x) has weighted turnover 4.85x — identifying and liquidating the 10% non-moving at 50% realisation releases ₹2 lakh cash.
Final Notes
Indian retailers like DMart maintain inventory days below 30 — the structural advantage that supports their margin. Use Tally Prime stock reports or specialised software (Marg, Zoho Inventory) to track movement patterns. Combine ABC classification with cycle-counting (perpetual inventory verification) to maintain accuracy without yearly disruption.
GST Implications on Inventory
Under GST, inventory valuation includes purchase price + freight + all costs to bring goods to current location and condition. GST paid on purchase (if ITC-eligible) is NOT part of inventory cost — it’s recorded separately as Input Tax Credit. Blocked credits (motor vehicles for personal use, certain construction services, food & beverage from outdoor caterers, etc.) cannot be claimed as ITC and must be added to inventory cost. Inter-state transfers attract IGST and need separate GSTIN ledgers. Year-end stock reconciliation is required for GSTR-9 annual return — variances must be explained to GST officer. Many Indian SMEs underestimate the GST-inventory linkage and end up with notice from the proper officer during GST audit.