Inventory valuation: FIFO, weighted average, LIFO and net realisable value

Inventory is often the largest current asset a retailer, wholesaler or manufacturer has, and the way it's valued flows straight into gross profit. Get it wrong and both the statement of financial position and profit are misstated — and the error carries into the next period, because this year's closing inventory is next year's opening inventory.

Valuing inventory involves three questions: what goes into cost, which cost goes to the units sold (the cost formula), and whether the inventory is still worth its cost (net realisable value). This guide answers all three with one worked example.

What goes into cost

Under IAS 2 Inventories, cost includes everything incurred to bring inventory to its present location and condition:

• the purchase price, including import duties and non-recoverable taxes, less trade discounts and rebates;
• inbound transport and handling (freight-in);
• for manufactured goods, direct materials, direct labour and a systematic allocation of production overheads based on normal capacity.

Cost excludes abnormal waste, storage costs (unless storage is a necessary part of production), administrative overheads that don't relate to production, and selling costs — including delivery to customers. Recoverable taxes such as VAT that can be reclaimed are also excluded.

Periodic and perpetual systems

A perpetual system updates inventory and cost of sales with every purchase and sale, so the records always show what should be on hand. A periodic system records purchases and works out cost of sales at the period end from a physical count: opening inventory + purchases − closing inventory = cost of sales. Most businesses with point-of-sale or ERP systems run perpetual records and still count periodically to find shrinkage. The choice can change the answer under weighted average and LIFO, as the example shows. The periodic and perpetual systems lesson has the entries for each.

Cost formulas

When items are interchangeable, you can't sensibly track which physical unit was sold, so a cost formula assigns cost:

• Specific identification — for items that aren't interchangeable, such as custom-built machines or individual cars. The actual cost of each item is tracked.
• FIFO (first-in, first-out) — the oldest costs go to cost of sales first, so closing inventory carries the most recent costs.
• Weighted average cost — cost of sales and closing inventory use an average cost. In a periodic system the average is calculated once for the period; in a perpetual system it's recalculated after every purchase (a "moving average").
• LIFO (last-in, first-out) — the newest costs go to cost of sales first. IFRS does not permit LIFO; IAS 2 allows only specific identification, FIFO and weighted average. LIFO is permitted under US GAAP, where some companies use it (often because US tax rules require companies that use LIFO for tax to use it in their financial statements too).

A company uses the same formula for all inventories of a similar nature and use.

A worked example: Tamsin Outdoor Supply

Tamsin Outdoor Supply sells one model of camping stove for 40 each. January's movements:

Goods available for sale: 450 units costing 10,300. Units sold: 350, for revenue of 14,000. Closing inventory: 100 units. The question is how the 10,300 is split between cost of sales and closing inventory.

FIFO

Closing inventory is the most recent 100 units: 100 × 25.00 = 2,500. Cost of sales = 10,300 − 2,500 = 7,800.

You get the same answer sale by sale: the 15 January sale uses 100 × 20.00 + 80 × 22.00 = 3,760; the 28 January sale uses the remaining 70 × 22.00 + 100 × 25.00 = 4,040; 3,760 + 4,040 = 7,800. FIFO gives the same result in periodic and perpetual systems.

Weighted average — periodic

Average cost for the month = 10,300 ÷ 450 = 22.889 per unit. To avoid rounding drift, allocate the total: cost of sales = 10,300 × 350 ÷ 450 = 8,011.11; closing inventory = 10,300 × 100 ÷ 450 = 2,288.89.

Weighted average — perpetual (moving average)

After the 10 January purchase: 250 units costing 5,300, an average of 21.20. The 15 January sale costs 180 × 21.20 = 3,816, leaving 70 units at 1,484. After the 20 January purchase: 270 units costing 6,484, an average of 24.0148. The 28 January sale costs 6,484 × 170 ÷ 270 = 4,082.52, leaving 100 units at 2,401.48. Cost of sales = 3,816 + 4,082.52 = 7,898.52.

LIFO — periodic (US GAAP only)

Closing inventory is the oldest 100 units: 100 × 20.00 = 2,000. Cost of sales = 8,300. (A perpetual LIFO calculation, applying the latest cost at each sale date, gives closing inventory of 2,150 — another reason LIFO results depend on the system.)

The comparison

In every row, cost of sales plus closing inventory equals 10,300. With rising prices, FIFO gives the highest closing inventory and profit, LIFO the lowest, and weighted average sits between. With falling prices the order reverses. Over the life of the business total cost of sales is the same; the methods only change the timing.

Try the same comparison on your own purchases with the inventory costing calculator.

Net realisable value: is it still worth cost?

Under IFRS, inventory is measured at the lower of cost and net realisable value (NRV). NRV is the estimated selling price in the ordinary course of business, less the estimated costs to complete the item and to make the sale. Inventory is written down when it's damaged, obsolete, slow-moving or when selling prices fall.

Continuing the example. On 31 January a newer stove model is announced. Tamsin expects to sell its remaining 100 stoves for 24.00 each, with selling costs of 1.50 each. NRV = 100 × (24.00 − 1.50) = 2,250.

Under FIFO the entry is: debit Inventory write-down (presented within cost of sales) 250; credit Inventory 250.

Points to remember:

• Item by item. Write-downs are usually made item by item, or for groups of similar related items — not by netting losses on one product line against gains on another.
• Use the evidence available. Events after the year-end that confirm conditions at the year-end — such as sales at lower prices in the following weeks — are used to estimate NRV.
• Reversals. Under IFRS, if NRV later recovers while the inventory is still held, the write-down is reversed, but never above original cost. Under US GAAP, a write-down creates a new cost basis and is not reversed.
• US GAAP measurement. Inventory measured using FIFO or average cost is carried at the lower of cost and net realisable value, as under IFRS. Inventory measured using LIFO or the retail inventory method is still measured at the lower of cost or market, a different test based on replacement cost within limits.

Common mistakes

• Including delivery to customers, storage or general admin costs in inventory cost.
• Averaging per-unit costs that were rounded, so cost of sales and closing inventory don't add back to goods available.
• Applying LIFO in IFRS statements.
• Comparing total cost with total NRV across unrelated product lines, hiding a loss on one line.
• Forgetting that an overstatement of closing inventory overstates this year's profit and understates next year's.

Frequently asked questions

Which method should a business choose?

The one that best reflects how inventory flows and gives reliable information, applied consistently. FIFO often mirrors physical flow for perishable goods; weighted average suits bulk, mixed stock such as fuel or grain.

Can a company change its cost formula?

Only if the change results in more reliable and relevant information. It's a change in accounting policy, applied retrospectively under IAS 8.

Why does IFRS prohibit LIFO?

Because LIFO usually leaves very old costs in the statement of financial position, so inventory no longer reflects recent cost levels.

Practise it

The graded lessons on inventory cost formulas and lower of cost and net realisable value include table exercises like the one above. The Inventory Valuation case puts you in a wholesaler's year-end count, with cut-off and NRV decisions. The Retail industry lesson covers returns and loyalty points, and the Month-end accountant pathway places inventory in the full close.