Inventory costing: FIFO vs weighted average

The short answer

Inventory costing is the method used to split the cost of goods available for sale between goods sold (cost of goods sold) and goods still on hand (closing inventory) when identical items were bought at different prices. FIFO assumes the oldest units are sold first; weighted average spreads the cost evenly across all units. The choice matters because it changes reported profit, the inventory balance and, often, tax.

IAS 2 Inventories allows only these two cost formulas for items that are interchangeable, and requires specific identification for items that are not. LIFO, which assumes the newest units are sold first, is not permitted under IFRS. Whatever the formula, inventory is then carried at the lower of cost and net realisable value.

Why a cost formula is needed at all

If every item were unique, like a car with a chassis number or a commissioned painting, you would simply record the cost of the actual item sold. IAS 2 paragraph 23 requires exactly that, specific identification, for items that are not ordinarily interchangeable and for goods produced for specific projects.

Most inventory is not like that. A shop selling one model of kettle has hundreds of identical units in the warehouse, bought in different batches at different prices. Nobody tracks which physical kettle left in which box, and it would make no economic difference if they did. A cost formula is a consistent rule for assigning costs to identical units. IAS 2 paragraph 25 requires the cost of such inventories to be assigned using first-in, first-out (FIFO) or weighted average cost, and the same formula must be used for all inventories of a similar nature and use.

What counts as cost in the first place

Before choosing a formula, the cost of each batch must be right. Under IAS 2, cost includes all costs of purchase, costs of conversion (for manufacturers) and other costs incurred in bringing the inventory to its present location and condition. For a trader, that means the purchase price plus import duties, non-recoverable taxes and inbound transport and handling, less trade discounts and rebates. Our guide on cost accounting basics shows how manufacturers build the conversion cost.

Some costs are excluded and must be expensed when incurred: abnormal waste, storage costs (unless storage is a necessary part of production), administrative overheads that do not help bring inventory to its location and condition, and selling costs. VAT that the business can reclaim is not part of cost; VAT it cannot reclaim is.

• Included: purchase price, import duties, non-recoverable taxes, freight in, handling, and for manufacturers direct labour and a systematic allocation of production overheads.
• Deducted: trade discounts, rebates and similar items.
• Excluded: recoverable VAT, abnormal waste, general storage, administration unrelated to production, and selling and distribution costs.

Perpetual versus periodic inventory systems

A perpetual system updates the inventory record with every purchase and every sale, so cost of goods sold is calculated as each sale happens and the book quantity is always available. A periodic system records purchases during the period and calculates cost of goods sold only at the end, as opening inventory plus purchases minus closing inventory from a physical count.

The system interacts with the formula. FIFO gives the same answer on both systems, because the oldest units are always the oldest. Weighted average does not: a periodic weighted average uses one average for the whole period, while a perpetual system recalculates the average after every purchase, a method usually called moving average. IAS 2 accepts both: the average may be calculated periodically or as each additional shipment is received, depending on the circumstances of the entity. Even a perpetual system needs periodic counts, because theft, damage and recording errors make the book quantity drift from reality.

The worked example: one month of kettles

Nordic Kettle Co sells one model of kettle for EUR 40 each. Its June movements are listed below. Over the month it had 480 units available, costing 11,460 in total, and sold 350, so 130 units remain. Revenue is 350 times 40, which is 14,000. The only question is how the 11,460 of cost is split between the 350 units sold and the 130 still on hand.

The sections that follow split that same 11,460 four ways. In every case cost of goods sold plus closing inventory must add back to 11,460, which is the simplest check that a calculation is complete.

• 1 June: opening inventory of 100 units at 20 each, 2,000.
• 5 June: purchase of 200 units at 23 each, 4,600.
• 12 June: sale of 180 units.
• 18 June: purchase of 180 units at 27 each, 4,860.
• 25 June: sale of 170 units.
• 30 June: 130 units remain.

FIFO worked through

Under FIFO the units sold are costed from the oldest layers first. The 12 June sale of 180 units takes all 100 opening units at 20 (2,000) and 80 of the 5 June units at 23 (1,840), a cost of 3,840. That leaves 120 units at 23. The 25 June sale of 170 units takes those 120 at 23 (2,760) and 50 of the 18 June units at 27 (1,350), a cost of 4,110.

Cost of goods sold is 3,840 plus 4,110, which is 7,950. Closing inventory is the 130 newest units at 27, which is 3,510. Check: 7,950 plus 3,510 equals 11,460. Gross profit is 14,000 minus 7,950, which is 6,050.

Because FIFO leaves the newest costs on the balance sheet, closing inventory is close to current replacement cost, which is its main advantage. When prices are rising, cost of goods sold uses older, cheaper costs, so FIFO reports the highest profit of the formulas, and part of that profit is simply inflation on stock that must be replaced at higher prices. Our guide on gross profit versus net profit shows how that margin flows through the income statement.

Weighted average worked through, both ways

Periodic weighted average uses one average for the month: total cost of 11,460 divided by 480 units available is 23.875 per unit. Cost of goods sold is 350 times 23.875, which is 8,356.25, and closing inventory is 130 times 23.875, which is 3,103.75. Check: 8,356.25 plus 3,103.75 equals 11,460. Gross profit is 5,643.75.

Moving (perpetual) weighted average recalculates after each purchase. After 5 June the business holds 300 units costing 2,000 plus 4,600, which is 6,600, an average of 22. The 12 June sale costs 180 times 22, which is 3,960, leaving 120 units at 22, or 2,640. After 18 June it holds 300 units costing 2,640 plus 4,860, which is 7,500, a new average of 25. The 25 June sale costs 170 times 25, which is 4,250, leaving 130 units at 25, or 3,250.

Moving-average cost of goods sold is 3,960 plus 4,250, which is 8,210, and closing inventory is 3,250. Check: 8,210 plus 3,250 equals 11,460. Gross profit is 5,790. Weighted average smooths price swings, so margins move less from month to month, which many businesses with frequent, volatile purchases prefer.

Comparing the results, and why LIFO is prohibited

LIFO assumes the newest units are sold first. On a periodic basis, the 350 units sold would be costed as the 180 bought at 27 (4,860) plus 170 of those bought at 23 (3,910), a cost of goods sold of 8,770. Closing inventory would be 30 units at 23 plus 100 at 20, which is 2,690, and gross profit 5,230.

The IASB removed LIFO from IAS 2 in its 2003 revision because LIFO does not faithfully represent how inventory actually flows and can leave balance sheet inventory at costs that are years or decades out of date. LIFO is not permitted under IFRS, under the IFRS for SMEs Accounting Standard or under Canada's ASPE. It remains permitted under US GAAP, which is one of the recurring differences for cross-border groups; our guides on IFRS versus US GAAP, IFRS for SMEs and IFRS versus ASPE cover the frameworks involved. The figures below show why the choice matters when prices are rising.

• FIFO: cost of goods sold 7,950; closing inventory 3,510; gross profit 6,050.
• Moving weighted average: cost of goods sold 8,210; closing inventory 3,250; gross profit 5,790.
• Periodic weighted average: cost of goods sold 8,356.25; closing inventory 3,103.75; gross profit 5,643.75.
• LIFO, shown only for comparison and not permitted under IFRS: cost of goods sold 8,770; closing inventory 2,690; gross profit 5,230.
• When prices fall, the ranking reverses: FIFO then reports the lowest profit.

Lower of cost and net realisable value

IAS 2 paragraph 9 requires inventory to be measured at the lower of cost and net realisable value. Net realisable value (NRV) is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. The comparison is normally made item by item, or for groups of similar items, never for inventory as a whole.

Suppose that at 30 June a competitor launches a better kettle and Nordic Kettle Co must cut its price to 28, with selling costs of 3 per unit. NRV is 25 per unit. Under FIFO the 130 units cost 27 each, so they are written down by 2 each, a total of 260: Dr Cost of goods sold (inventory write-down) 260 / Cr Inventory 260. Closing inventory becomes 3,250. Under moving average the cost is exactly 25, and under periodic weighted average it is 23.875, so no write-down is needed. The same economic event produces a loss under one formula and none under the others.

If the price recovers while the kettles are still held, IAS 2 paragraph 33 requires the write-down to be reversed, but only up to the original cost. If NRV rose to 29 in July, the FIFO write-down of 260 would be reversed in full, restoring the cost of 27, and never beyond it.

Choosing a formula and changing it

Choose the formula that best reflects how the business buys and sells, then apply it consistently. FIFO suits perishable goods and goods with expiry dates, where physical flow really is first in, first out, and it keeps the balance sheet close to current cost. Weighted average suits bulk and commingled goods such as fuel, grain or chemicals, and businesses that want smoother margins. Different formulas can be used for inventories of a genuinely different nature or use, but not to manage profit.

Changing formula is a change in accounting policy under IAS 8 and is allowed only if the new policy gives reliable and more relevant information. It is applied retrospectively, which means restating comparatives as if the new formula had always been used, and the reason must be disclosed. Tax authorities may also have their own rules on inventory valuation, so check the tax consequences before any change.

How Skyline Nexus ERP costs inventory

Skyline Nexus ERP costs stock by purchase lot. Under Settings, Business Settings, the Stock Accounting Method field offers FIFO (First In First Out) or LIFO (Last In First Out), and the choice decides which purchase lot each sale consumes. That consumed lot's tax-exclusive cost is what posts as cost of goods sold, debiting cost of goods sold and crediting inventory in the ledger when sales auto-posting is switched on. For a business reporting under IFRS, FIFO is the compatible choice, since IAS 2 does not permit LIFO.

Stock is held per business location, and the Inventory Control Centre includes a Stock Valuation Report, a Location Wise Stock Report, a Stock Movement Report, a Physical Stock Verification report for counts, a Dead Stock / Slow Moving Items Report that helps identify candidates for a net realisable value review, and a FIFO/LIFO Inventory Valuation Report. Any write-down to net realisable value is recorded by the accountant as a manual journal, like the one in the example above.

Related guides

Inventory costing connects to several other topics in the accounting basics series.

• Journal entries with examples: recording purchases, sales and returns of inventory on the perpetual system.
• Adjusting entries explained: stock count differences and write-downs to net realisable value at year end.
• How to read financial statements: where inventory and cost of sales appear and how to calculate inventory days.
• IFRS vs US GAAP: LIFO and write-down reversals as practical differences for cross-border groups.
• Cost accounting basics: how manufacturers build product cost before a cost formula is applied.
• Gross profit versus net profit: how cost of sales shapes the margin.
• Financial ratio analysis: inventory turnover and days computed and interpreted.