FIFO or Weighted Average: Inventory Valuation and Its Effect

Two businesses can buy identical goods, sell identical quantities at identical prices, and report different profits. The only difference is which cost formula they use to decide what the goods they sold had cost them.

In India the practical choice is between first-in-first-out and weighted average. Last-in-first-out is not permitted under Indian accounting standards (AS 2 and Ind AS 2 allow only FIFO or weighted average where items are not specifically identified), which is worth stating plainly because a great deal of material written for a United States audience discusses LIFO at length and is simply not applicable here.

What each formula assumes

FIFO assumes the oldest stock is sold first. Cost of goods sold carries the earliest prices; closing stock carries the most recent ones.

Weighted average makes no assumption about which physical unit left. It pools cost and divides by quantity, so every unit sold and every unit remaining carries the same blended cost.

Neither is a claim about what physically happened in the warehouse. A petrol pump physically operates on something close to FIFO whatever formula it uses; a bulk grain silo genuinely blends. The formula is a costing convention, and the standard permits either provided it is applied consistently.

One month, valued both ways

A trader deals in a single product. Prices rise through the month, which is the condition under which the two formulas diverge.

Total purchases and opening stock: 750 units costing ₹4,07,000. Sold: 600 units. Remaining: 150. All sales at ₹800 a unit, so revenue is ₹4,80,000.

Under FIFO

The 16 April sale of 400 units takes the oldest first: 200 at ₹500 (₹1,00,000) then 200 at ₹540 (₹1,08,000), a cost of ₹2,08,000. That leaves 100 units at ₹540.

The 28 April sale of 200 units takes those 100 at ₹540 (₹54,000) then 100 at ₹580 (₹58,000), a cost of ₹1,12,000.

Cost of goods sold ₹3,20,000. Closing stock 150 units at ₹580 = ₹87,000.

Under weighted average

Recomputed after each purchase, which is how a perpetual system works.

Before the 16 April sale: 500 units costing ₹2,62,000, an average of ₹524. The sale of 400 costs ₹2,09,600, leaving 100 units at ₹524, or ₹52,400.

After the 22 April purchase: 350 units costing ₹52,400 + ₹1,45,000 = ₹1,97,400, an average of ₹564. The sale of 200 costs ₹1,12,800.

Cost of goods sold ₹3,22,400. Closing stock 150 units at ₹564 = ₹84,600.

The comparison

Three things to read off this.

FIFO reports more profit when prices are rising, because it charges older, cheaper stock against current selling prices. The effect reverses when prices fall.

The difference appears twice, identically. ₹2,400 of extra profit and ₹2,400 of extra closing stock. That is not a coincidence: whatever you do not charge to cost of goods sold stays on the balance sheet.

It is a timing difference, not a permanent one. Sell the remaining 150 units next month and the cumulative profit across the two months is identical under both formulas. Only the period in which it appears changes.

Why the difference here is small, and when it is not

₹2,400 on ₹4,80,000 of revenue is half a percentage point of margin. That is because prices moved 16% over a month and stock turned over quickly.

The divergence grows with two things: how fast input prices move, and how slowly stock turns. A business holding four months of stock through a period of sharp cost inflation can see a materially different gross margin under the two formulas. A business turning stock weekly will barely notice.

If your inventory sits for a long time and your input costs are volatile, the choice is worth thinking about. Otherwise it rarely earns the attention it gets.

Choosing, and then living with it

FIFO leaves a closing stock figure close to current replacement cost, which makes the balance sheet more informative. It is the usual choice for goods with a shelf life or identifiable batches, where the physical flow genuinely is first in first out.

Weighted average smooths the effect of price swings on reported margin and is simpler to run where stock is homogeneous and pooled. It is the usual choice for commodities and bulk materials.

The constraint that matters more than the choice is consistency. You apply the same formula to inventories of similar nature and use, and you keep applying it. Switching formulas is a change in accounting policy, needs disclosure, and will be read as an attempt to move profit unless there is a real reason. Picking whichever flatters this year’s numbers is exactly what the consistency requirement exists to prevent.

The rule that overrides both

Whichever formula you use, inventory is carried at the lower of cost and net realisable value. If those 150 units can now only be sold for ₹520 each after selling costs, they are written down to ₹78,000 regardless of whether cost was ₹87,000 or ₹84,600.

Obsolete and slow-moving stock is where real inventory losses live, and no cost formula protects against it. A stock ledger that has never recorded a write-down in a business holding physical goods is a stock ledger worth questioning.

Where this fits

• Where closing stock lands: from trial balance to balance sheet
• What stock does to your funding: how much working capital you need
• Reading the finished statement: how to read a balance sheet
• First principles: accounting for beginners