Inventory Valuation: FIFO vs Weighted Average and Its Profit Effect

Picture two shops on the same street. They buy the same goods from the same supplier on the same days, sell the same number of units at the same price, and end the year holding the same 150 units on the shelf. Yet one reports a fatter profit than the other. Nothing was faked. The only difference is the inventory valuation method each one chose — FIFO or weighted average. That single accounting choice decides how much of your buying cost stays on the balance sheet as closing stock and how much drops into the profit and loss account as cost of goods sold. This guide walks the two methods through one worked example on identical data, shows exactly where the profit gap comes from, and covers the rules every Indian business must follow — including why LIFO is off the table.

Same purchases, same sales, same period — only the valuation method differs. Full workings below.

What inventory valuation actually decides

Inventory is money you have already spent but not yet turned into profit. When you buy stock, the cash leaves, but the expense does not hit your profit and loss account straight away. It waits inside the asset called inventory until the goods are sold. Only then does that cost become cost of goods sold (COGS) and reduce your profit.

So at year-end you face one question: of everything you bought, how much cost belongs to the units still sitting in the warehouse (closing stock, an asset), and how much belongs to the units that walked out the door (COGS, an expense)? The two must add up to the total cost you incurred. Push more cost into closing stock and COGS falls, so profit rises. Push more into COGS and profit falls.

That is the whole game: inventory valuation is simply the rule that splits one pot of cost between the shelf and the income statement. Because closing stock and profit move in opposite directions from the same pool, the method you pick is not a back-office technicality — it changes the profit you report, the tax you may pay, and the net worth on your balance sheet. If you want this foundation built properly rather than pieced together from scattered videos, a structured accounting course compresses the confusing parts into a clear sequence.

FIFO vs weighted average: the two methods India allows

Indian accounting standards recognise two cost formulas for interchangeable inventory, and only two. The choice is genuine, but it is bounded.

FIFO (First-In, First-Out)

FIFO assumes the oldest units are sold first. It does not require you to physically move the oldest goods — it is a costing assumption, not a warehouse instruction. The consequence is simple and worth memorising: because the earliest (cheapest, in a rising market) costs flow out as COGS, the units left in closing stock are valued at the most recent purchase prices. In an economy where prices generally drift up, FIFO leaves your balance sheet holding stock at near-current cost, which most accountants consider a realistic picture of what the inventory is worth.

Weighted average cost

The weighted average method blends every rupee of purchase cost into a single average rate per unit, then values both the goods sold and the goods remaining at that same average. Every unit is treated as identical in cost, regardless of when it arrived. This smooths out price swings: a sudden spike in one purchase lot is diluted across the whole pool rather than landing entirely on one batch. For businesses that buy the same commodity repeatedly — a steel trader, a grain wholesaler, a pharmacy — the weighted average is often simpler to run and less jumpy period to period.

What about LIFO? Last-In, First-Out is taught in many textbooks but it is not permitted in India. Ind AS 2, the older AS 2 issued by the ICAI, and ICDS-II under income tax all allow only FIFO and weighted average. This mirrors global standards — IAS 2 withdrew LIFO years ago because it can undervalue closing stock and distort the balance sheet during inflation. So while you may read about LIFO, you cannot use it in Indian financial statements or tax returns. We cover the wider financial-reporting picture in our guide to the ACCA Financial Accounting paper, where inventory under IAS 2 is an examinable topic.

The same purchases, two profits — a worked example

Numbers settle the argument faster than definitions. Take one product bought over a single period at steadily rising rates, exactly as charted above. Here is the buying record.

During the period you sell 450 units at ₹350 each, so sales are ₹1,57,500 and closing stock is 600 − 450 = 150 units. The total cost pool is ₹1,45,000 whichever method you use. All that changes is how that pool is split.

Under FIFO, the 150 units left are assumed to be the newest, so they carry the last purchase price: 150 × ₹280 = ₹42,000 closing stock. COGS is therefore ₹1,45,000 − ₹42,000 = ₹1,03,000, and gross profit is ₹1,57,500 − ₹1,03,000 = ₹54,500.

Under weighted average, the average cost is ₹1,45,000 ÷ 600 = ₹241.67 per unit. Closing stock is 150 × ₹241.67 = ₹36,250, COGS is 450 × ₹241.67 = ₹1,08,750, and gross profit is ₹1,57,500 − ₹1,08,750 = ₹48,750.

The gap is real but it is not magic. FIFO parks the newest, dearest costs in closing stock, so less cost flows to COGS and profit looks higher. Weighted average spreads the dearer later purchases across every unit, lifting COGS a little and trimming profit. Over the product's entire life the two methods report the same total profit — the difference is only about timing, about which period gets the profit. This is the same idea we explored with depreciation methods, where the choice between straight line and written down value shifts profit between years without changing the lifetime total.

FIFO vs weighted average — which should you use?

There is no universally correct answer; there is a fit for your business. Both are acceptable under Indian standards, so the decision rests on the nature of your stock, the stability of your prices, and the story you want your accounts to tell honestly.

A dairy or a medicine retailer, where old stock genuinely must sell first, leans naturally to FIFO. A cement dealer or an oil trader buying identical bulk loads finds the weighted average both simpler and fairer. Whatever you pick, apply the same method consistently to all inventory of a similar nature, and use the same formula from one year to the next unless there is a sound reason to change and you disclose it.

The rule that overrides both: lower of cost or NRV

FIFO and weighted average both tell you the cost of your closing stock. But Indian standards add a safety valve. Inventory must be carried at the lower of cost and net realisable value (NRV) — because no asset should sit on the balance sheet at more than you can actually recover by selling it.

NRV is the estimated selling price in the ordinary course of business, minus the estimated costs to complete the goods and the estimated costs needed to sell them. If your closing stock cost ₹42,000 under FIFO but the goods are now damaged, out of fashion, or overtaken by a cheaper import and will fetch only ₹35,000 net, you write the stock down to ₹35,000 and book the ₹7,000 fall as an expense this year. If cost is lower than NRV, you leave it at cost — you never write inventory up above cost.

Two details trip people up. First, the comparison is normally made item by item, not on the whole stock lumped together, so a loss on one line is not hidden by a gain on another. Second, cost here means the full cost of bringing the goods to their present location and condition — purchase price plus freight, duties and conversion, net of trade discounts — not just the invoice figure.

Common mistakes and what to remember

Inventory valuation looks simple until a real ledger lands on your desk. These are the errors that show up most often.

• Reaching for LIFO. It is in the textbooks and in some overseas systems, but it is not allowed in Indian financial statements or under ICDS-II. Do not build a habit you cannot use.
• Switching methods to flatter profit. Consistency is a principle, not a suggestion. Hopping between FIFO and weighted average to smooth results distorts comparison and invites audit questions.
• Forgetting the NRV test. Cost is only the starting point. Slow-moving and obsolete stock must be written down, or your balance sheet overstates both assets and profit.
• Loading the wrong costs into inventory. Freight inward and duties belong in cost; selling and distribution costs and abnormal wastage do not.
• Mistaking timing for magic. FIFO does not create profit. It moves profit between periods. The lifetime total is identical either way.

Get these right and inventory stops being a mystery. It becomes what it should be: an honest measure of value on the shelf and a clean line between the cost of what you sold and the cost of what you still hold. These threads — the asset, the expense, the double entry behind them — all sit on the same foundation we lay out in double-entry bookkeeping basics.

Frequently Asked Questions

Is FIFO or weighted average better for inventory valuation?

Neither is universally better; both are allowed in India. FIFO values closing stock near current cost and suits perishable or dated goods where old stock must sell first. Weighted average smooths price swings and suits bulk, interchangeable commodities. Pick the one that fits your stock, then apply it consistently every year.

Why is LIFO not allowed in India?

Last-In, First-Out is prohibited under Ind AS 2, the ICAI's AS 2, and ICDS-II for income tax. During inflation LIFO can leave closing stock valued at very old, low prices, understating the asset on the balance sheet. India follows the global position — IAS 2 withdrew LIFO for the same reason — so it cannot be used in Indian accounts or tax returns.

Does the inventory valuation method change my total profit?

Not over the life of the goods. FIFO and weighted average split the same cost pool differently between closing stock and cost of goods sold, so they change profit in any single period. But once all the stock is sold, the cumulative profit is identical. The method affects timing, not the lifetime total.

What is net realisable value (NRV) in inventory?

NRV is the estimated selling price of your inventory in the ordinary course of business, minus the estimated costs to complete the goods and the costs needed to sell them. Indian standards require inventory to be carried at the lower of cost and NRV, so damaged or slow-moving stock is written down to what it can actually fetch.

How do I calculate weighted average cost per unit?

Add the total cost of all units available for sale, then divide by the total number of units. In our example, ₹1,45,000 of cost across 600 units gives an average of ₹241.67 per unit. You then value both the units sold and the units in closing stock at that same rate, which is what smooths out the price differences between purchase lots.