Inventory: Measurement and Cost Flow Methods

Learning objectives

By the end of this chapter, you should be able to:

• Calculate closing inventory and cost of sales using FIFO and weighted average cost methods.
• Record period-end inventory adjustments so that inventory (asset) and cost of sales (expense) are stated correctly.
• Apply the lower of cost and net realisable value (NRV) rule to ensure inventory is not overstated.
• Explain how different inventory valuation methods affect profit, assets, and selected performance measures.
• Identify and correct common inventory errors, including cut-off mistakes and misclassification of costs.

Overview & key concepts

Inventory is often one of the largest current assets in a trading or manufacturing business. Its valuation matters because the same number influences:

• Statement of financial position:inventory is reported as an asset.
• Profit or loss:inventory valuation affectscost of sales, which drivesgross profit.

A small error in closing inventory can create a large distortion in reported results. For example:

• Overstating closing inventoryreduces cost of sales and increases profit and assets.
• Understating closing inventoryincreases cost of sales and reduces profit and assets.

This chapter focuses on:

• Cost flow assumptions:FIFO and weighted average cost (AVCO).
• Prudence in measurement:applyinglower of cost and NRV.
• Period-end entries:ensuring the correct split between inventory (asset) and cost of sales (expense).

Inventory and why it matters

What counts as inventory?

Inventory includes items held:

• for resale (e.g. a retailer’s goods),
• in production (work in progress),
• as materials to be consumed in production or service delivery (raw materials, consumables).

Inventory is a current asset because it is expected to be sold or used within the normal operating cycle.

Cost of sales and gross profit

Cost of sales represents the cost of inventory that has been sold during the period. Under a periodic system, it is commonly calculated as:

Cost of sales = Opening inventory + Purchases − Closing inventory

Gross profit is then:

Gross profit = Revenue − Cost of sales

Illustration:
Opening inventory £10,000, purchases £50,000, closing inventory £15,000:

• Cost of sales = £10,000 + £50,000 − £15,000 =£45,000
• Gross profit increases if closing inventory is higher (because cost of sales is lower), and falls if closing inventory is lower.

Core theory and frameworks

Measuring inventory cost

What goes into inventory cost (a rule you can apply in questions)

Include a cost only if it is necessary to get the inventory to a saleable/usable state at its present location. A quick test is:

Would this cost have been incurred if the goods had not been bought or made?
If yes, and it is directly linked to getting the goods ready, it is usually included in inventory cost.

Common inclusions (typical scenarios):

• net purchase price (after trade discounts)
• import duties and other non-recoverable purchase taxes
• delivery and handling to bring goods in (e.g. carriage inwards)
• for manufactured goods: direct materials, direct labour, andproduction overheads absorbed on a normal (expected) capacity basis
• (abnormal/unexpected overheads are expensed)

Common exclusions (charged as period costs):

• abnormal or avoidable losses (unusual waste, rework caused by errors)
• selling activity costs (marketing, sales commissions, distribution)
• general administration not connected to getting goods ready
• storage costsunlessstorage is an unavoidable part of the production process before the next stage (in basic questions this is uncommon, but it prevents a blanket “always exclude” approach)

Illustration:
Invoice price £1,000 less trade discount 10% = £900.
Carriage inwards £50.
Inventory cost = £950.

Cost flow methods

A cost flow method determines how unit costs are assigned to:

• cost of sales(expense), and
• closing inventory(asset).

The method does not have to match physical movement, but it must be applied consistently for comparability.

Permitted methods: FIFO and weighted average cost (AVCO) are permitted. LIFO is not allowed.

FIFO (First-In, First-Out)

FIFO assumes the earliest costs are charged to cost of sales first. As a result, closing inventory tends to reflect the most recent purchase costs.

In rising prices, FIFO usually produces:

• lowercost of sales,
• higherclosing inventory,
• higherprofit (all else equal).

Illustration:
Buy 100 units @ £5, then 100 units @ £6. Sell 150 units.
FIFO cost of sales = 100×£5 + 50×£6.
Closing inventory = 50×£6.

Weighted average cost (AVCO)

AVCO assigns a single average cost per unit to units sold and units remaining (for the period or after each receipt, depending on the system).

Average cost per unit (periodic approach):

Average cost = Total cost of goods available / Total units available

In rising prices, AVCO typically produces results between FIFO and the most recent purchase cost.

Illustration:
Total cost £2,000 for 200 units → average £10 per unit.
If 150 units sold, closing inventory (50 units) = 50×£10 = £500.

Recoverability and NRV

Recoverability check (cost vs expected recovery)

Inventory is accumulated at cost, but that cost is only meaningful if it can be recovered through sale or use. At each reporting date, apply a simple recoverability check:

• If the item can still be sold for at least its cost (after finishing and selling costs), keep it at cost.
• If not, reduce it to the amount you expect to recover.

Net realisable value (NRV) is the cash you expect to collect from selling the item after allowing for any further spend needed to finish it and make the sale. A practical computation is:

NRV = expected selling price − costs to complete − costs to sell

When do write-downs happen?

Write-downs commonly arise when goods are:

• damaged or deteriorated,
• obsolete or replaced by newer models,
• slow-moving and likely to require discounting,
• subject to increased completion or selling costs that reduce expected recovery.

How the write-down is reported

If NRV falls below cost, reduce the inventory carrying amount and recognise the reduction as an expense (often within cost of sales in exam questions, unless stated otherwise).

Typical entry (reducing inventory directly):

• Dr Cost of sales (or Inventory write-down expense)
• Cr Inventory

Some questions use an allowance (contra) account; the effect is the same: inventory is shown at the reduced amount.

Unit-of-account note

NRV is usually assessed item-by-item. Grouping is only appropriate where items are similar in nature and use and are sold in similar ways (for example, a related product line).

Periodic inventory system and period-end adjustments

In a periodic system:

• purchases are recorded during the period,
• inventory is counted and valued at the period end,
• cost of sales is derived from opening inventory, purchases, and closing inventory.

Why the period-end entries exist (periodic system)

Under a periodic approach, purchases are accumulated during the period and the inventory figure in the ledger often still reflects the opening amount. At the reporting date you “reset” inventory to what the count shows:

1. move opening inventory out of assets and into cost of sales; and
2. bring closing inventory back into assets, which reduces cost of sales.

This ensures the statement of financial position carries the counted closing inventory, and profit or loss reflects the inventory consumed.

Period-end journal entries (periodic approach)

(1) Transfer opening inventory to cost of sales

• Dr Cost of sales
• Cr Inventory

(2) Recognise closing inventory

• Dr Inventory
• Cr Cost of sales

Note on systems: Some systems operate a perpetual inventory ledger (inventory updated continuously and cost of sales recorded at each sale). In a periodic system, purchases are accumulated during the period and cost of sales is calculated at the period end using opening inventory, purchases and closing inventory. The journals shown here reflect the periodic approach used in many exam questions. Depending on the ledger design, entities may also close a Purchases account into cost of sales; questions often simplify to the two adjustments shown.

Impact on financial statements and performance measures

Inventory method choice affects:

• Gross profit and net profit(through cost of sales),
• Current assets and working capital(through closing inventory),
• Ratiossuch as:
  • gross profit margin,
  • current ratio,
  • inventory days / turnover.

In general, when purchase prices rise:

• FIFO increases profit and inventory relative to AVCO.
• AVCO produces smoother margins across periods.

The method does not change cash receipts and payments from trading, but it can affect taxable profit and therefore tax cash flows in practice. Questions usually focus on the effect on accounting profit and reported assets.

Worked example

Narrative scenario

A business, Widget Co., uses a periodic inventory system and sells one product (Widget A). The following transactions occurred in April:

• Opening inventory (1 April):60 units @ £8
• Purchases (5 April):100 units @ £9
• Purchases (18 April):80 units @ £10
• Sales during April:170 units
• Expected selling price per unit:£12
• Costs to complete and sell per unit:£2

Required

1. Calculate closing inventory using FIFO.
2. Calculate closing inventory using weighted average cost (AVCO).
3. Determine cost of sales for April under each method.
4. Apply the NRV test and record any necessary write-down.
5. Prepare the period-end journal entries (periodic system).

Solution

Rounding policy (used throughout this solution)

• Average cost per unit: calculate to4 decimal places.
• Monetary amounts: round to thenearest penny.

Step 1: Units available and units sold

Units available:

• Opening: 60
• Purchases: 100 + 80 = 180
• Total available =240 units

Units sold = 170 units
Closing inventory = 240 − 170 = 70 units

FIFO

FIFO cost of sales

Allocate the earliest costs to the 170 units sold:

• 60 units @ £8 = £480
• 100 units @ £9 = £900
• Remaining: 170 − (60 + 100) = 10 units @ £10 = £100

Total FIFO cost of sales = £1,480

FIFO closing inventory

Remaining inventory is valued at the latest purchase cost:

• Closing inventory: 70 units @ £10 =£700

Weighted average cost (AVCO) — periodic

Total cost of goods available

• Opening: 60 × £8 = £480
• Purchases: 100 × £9 = £900
• Purchases: 80 × £10 = £800

Total cost available = £2,180
Total units available = 240 units

Average cost per unit = £2,180 ÷ 240 = £9.0833

AVCO closing inventory and cost of sales

Closing inventory = 70 × £9.0833 = £635.83
Cost of sales = £2,180 − £635.83 = £1,544.17

NRV test

NRV per unit:

• Selling price £12 − costs to complete and sell £2 =£10

Compare cost vs NRV:

• FIFO closing inventory cost per unit = £10 → equals NRV →no write-down
• AVCO closing inventory cost per unit ≈ £9.0833 → below NRV →no write-down

Conclusion: No inventory write-down is required.

Journal entries (periodic system)

(1) Transfer opening inventory to cost of sales

Opening inventory value: 60 × £8 = £480

• Dr Cost of sales £480
• Cr Inventory £480

(2) Recognise closing inventory

If FIFO is used (closing inventory £700):

• Dr Inventory £700
• Cr Cost of sales £700

If AVCO is used (closing inventory £635.83):

• Dr Inventory £635.83
• Cr Cost of sales £635.83

(3) If a write-down were required (general format)

• Dr Cost of sales (or Inventory write-down expense)
• Cr Inventory(or allowance against inventory)

(No entry is needed in this scenario.)

Interpretation of the results

Prices increased from £8 to £10 during the month. Under FIFO, more of the earlier (lower) costs are charged to cost of sales. Therefore:

• FIFO cost of sales (£1,480) is lower than AVCO (£1,544.17).
• FIFO closing inventory (£700) is higher than AVCO (£635.83).

This produces a higher gross profit under FIFO for the period, even though the sales volume is unchanged.

Common pitfalls and misunderstandings

• Cut-off errors (goods in transit):recording purchases and inventory based on the wrong timing ofcontrol/ownership transfer under the delivery terms(e.g. FOB shipping point vs FOB destination; CIF). Use shipping terms as the anchor, supported by indicators such as legal title, physical possession, and who bears insurance and return obligations.
• Mixing up trade discounts and settlement discounts:trade discounts reduce inventory cost; settlement discounts are usually treated separately unless the question states otherwise.
• Including selling costs in inventory:advertising, sales commissions, and distribution are period costs, not inventory cost.
• Omitting carriage inwards:delivery to bring goods to their location is typically part of inventory cost when directly attributable.
• Misapplying FIFO:allocating recent costs to cost of sales first is not FIFO.
• Rounding inconsistently under AVCO:use a clear rounding policy and apply it consistently.
• Ignoring NRV indicators:damage, obsolescence, discounting, and rising completion/selling costs can trigger write-downs.
• Including recoverable taxes in cost:recoverable VAT should not be included in inventory.
• Switching methods without justification:inconsistency reduces comparability and can distort trends.

Summary and further reading

Inventory valuation affects both profit measurement and financial position. FIFO and weighted average cost are permitted cost flow methods and can produce different results when prices change. Inventory is carried at the lower of cost and NRV, using an item-by-item approach unless grouping is justified. Under a periodic system, period-end adjustments reset inventory from opening to closing and ensure cost of sales reflects the inventory consumed during the period.

FAQ

Why does inventory valuation matter so much?

Because closing inventory is an asset and also reduces cost of sales. An error can distort both financial position and profit.

In rising prices, why does FIFO usually increase profit?

FIFO charges older, cheaper costs into cost of sales first, lowering cost of sales and increasing gross profit compared with methods that blend or use later costs.

Which cost flow methods are allowed?

FIFO and weighted average cost are allowed. LIFO is not permitted.

When should NRV be considered?

NRV should be reviewed when there are signs inventory may not recover its cost—damage, obsolescence, slow-moving stock, price reductions, or higher completion/selling costs.

How is an inventory write-down recorded?

Reduce inventory to NRV and recognise an expense:

• Dr Cost of sales (or inventory write-down expense)
• Cr Inventory (or allowance)

What is the most common mistake with periodic inventory entries?

Recording closing inventory without removing opening inventory from the ledger. Under a periodic approach, both adjustments are needed to reset inventory and calculate cost of sales correctly.

Glossary

Inventory
Items held for resale, in production, or to be consumed in producing goods or services, reported as a current asset.

Cost of sales
The cost of inventory sold during a period, commonly calculated as opening inventory plus purchases minus closing inventory under a periodic system.

Closing inventory
Inventory on hand at the reporting date, valued using an appropriate cost method and reduced to NRV where necessary.

FIFO (First-In, First-Out)
A cost flow method where the oldest costs are allocated to cost of sales first, leaving closing inventory valued using more recent costs.

Weighted average cost (AVCO)
A method that assigns an average cost per unit to units sold and units remaining based on total cost and total units available.

Net realisable value (NRV)
Expected selling proceeds from inventory after deducting any further costs needed to complete and sell it.

Lower of cost and NRV
A measurement rule that ensures inventory is not carried above the amount expected to be recovered from sale.

Write-down
A reduction in inventory value when NRV is below cost, recognised as an expense.

Carriage inwards
Delivery costs incurred to bring purchased goods to their location, included in inventory cost when directly attributable.

Periodic inventory system
A system where inventory is counted at period end and cost of sales is derived from opening inventory, purchases, and closing inventory.