Inventory Valuation Methods: FIFO and Weighted Average

Learning objectives

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

• Explain FIFO and weighted average as inventory cost-flow methods and describe how each affects profit and inventory values.
• Calculate cost of sales and closing inventory using FIFO and theperiodicweighted average method.
• Identify which costs belong in inventory cost and which costs should be expensed.
• Apply good exam technique to avoid common errors, including incorrect batch allocation, early rounding, and weak reconciliations.

Overview & key concepts

Inventory valuation matters because it determines two headline numbers:

• Closing inventory(an asset on the statement of financial position)
• Cost of sales(an expense in the statement of profit or loss)

These two figures are linked: for a given set of purchases, if closing inventory is higher, cost of sales is lower (and gross profit is higher), and vice versa.

Lower of cost and NRV

In exam questions, inventory is normally reported at the lower of:

• cost, and
• net realisable value (NRV)— what the inventory is worth in a sale scenario at the reporting date: start with the expected selling price, then deduct (i) any further costs needed to finish or prepare the item for sale and (ii) anyunavoidableselling costs needed to complete the sale.

Only treat delivery as a selling cost for NRV where delivery is necessary to make the sale (for example, it is required by the sales contract), rather than routine distribution.

If NRV falls below cost, the item is written down so inventory is not overstated. If NRV later improves, earlier write-downs may be reversed, but only up to the amount previously written down.

FIFO (first in, first out)

FIFO allocates costs on the assumption that the earliest costs are issued (sold) first. As a result:

• Cost of salestends to reflect earlier purchase prices.
• Closing inventorytends to be priced at the most recent purchase costs.

In a period of rising prices, FIFO often produces higher closing inventory and higher gross profit (because older, cheaper costs flow into cost of sales).

Weighted average

Weighted average produces a single average cost per unit and uses it to value:

• units sold (cost of sales), and
• units remaining (closing inventory).

Two versions are commonly seen:

• Periodic weighted average: compute one average for the whole period (typical in questions that value inventory at period end).
• Moving (perpetual) weighted average: update the average after each purchase (used where records are updated continuously).

This chapter’s worked example uses the periodic method.

Cost-flow methods vs physical movement

FIFO and weighted average are cost allocation methods. They describe how costs are assigned to sales and closing inventory. They do not have to match how goods physically move through a warehouse.

Core theory and frameworks

Which costs form part of inventory cost?

Think of inventory cost as: (1) what you pay to buy or make it, plus (2) what you must spend to get it ready for sale in your business.

• For aretailer, this is mainly purchase-related costs (after trade discounts) and getting goods into the business (for example freight-in).
• For amanufacturer, this also includesconversion costs, such as direct labour and production overheads.

Production overheads are included using a sensible absorption approach: variable production overheads are typically absorbed based on actual production, while fixed production overheads are spread based on normal activity/capacity (so unit costs are not distorted by unusual highs or lows in output).

Include (typical items)

• purchase price (net of trade discounts/rebates)
• non-refundable import duties and similar taxes
• carriage inwards/freight-in and handling directly related to purchases
• costs of converting goods (where applicable): direct labour and production overheads appropriately absorbed

Exclude (typical items)

• carriage outwards/delivery to customers (routine distribution)
• sales commissions, marketing and advertising
• storageafter production or purchase(unless it is unavoidable in the production process)
• general administration not linked to making or preparing inventory
• abnormal losses (see below)

Carriage inwards and abnormal waste

• Carriage inwardsis normally included in inventory cost because it is part of acquiring goods into the business.
• Abnormal waste(unusual spoilage, damage, or loss beyond what is expected in normal operations) is charged as an expense in the period, not added to inventory cost.

FIFO methodology (periodic valuation)

Under FIFO, you allocate sales using the earliest available purchase costs first:

1. List purchases in date order (batches).
2. Issue units sold starting from the oldest batch and work forward.
3. Value closing inventory using the costs of the most recent unsold batches.

Periodic weighted average methodology

Under periodic weighted average:

1. Compute total units available for sale during the period.
2. Compute total cost of units available for sale.
3. Average cost per unit = total cost ÷ total units.
4. Value:
   • cost of sales = units sold × average cost per unit
   • closing inventory = units remaining × average cost per unit

Rounding: keep sufficient decimals during workings (for example 3–4 dp, or carry the unrounded fraction in your calculator) and round final figures as required by the question.

Double-entry logic (what the valuation affects)

Inventory valuation determines how the total cost of goods available for sale is split between:

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

Under a system with continuous inventory records, cost of sales may be recorded as each sale is made. Under a periodic approach, the financial statements are adjusted at the end of the period to recognise closing inventory and derive cost of sales. Whichever approach is used, the final outcome must be:

• closing inventory shown as an asset, and
• cost of sales recognised as an expense for the period.

Impact on financial statements

Because cost of sales affects gross profit, different cost-flow methods can change reported performance even when sales volumes are identical. When prices rise:

• FIFO often giveslower cost of salesandhigher inventorythan weighted average.
• Weighted average often produces results between older and newer purchase costs.

Borderline cases

Questions may include complications such as:

• mixed batches and partial issues,
• purchase returns,
• sales returns,
• write-downs to NRV and reversals.

Always apply the approach specified in the question and the entity’s stated policy. For NRV comparisons, apply item-by-item or groupingas instructed (and then keep the approach consistent).

Worked example

Narrative scenario

A retail business in the UK sells electronic gadgets. It uses a periodic inventory system and needs to value inventory at the end of January. The following transactions occurred:

• 3 January:Purchased 100 units at £8 each
• 10 January:Sold 50 units
• 15 January:Purchased 80 units at £9 each
• 20 January:Sold 60 units
• 25 January:Purchased 70 units at £10 each
• 30 January:Sold 40 units

A physical count on 31 January shows 100 units of inventory remaining.

Required

1. Calculate cost of sales using FIFO.
2. Calculate closing inventory value using FIFO.
3. Calculate cost of sales using the periodic weighted average method.
4. Calculate closing inventory value using the periodic weighted average method.
5. Compare the results and explain the impact on the financial statements.

Solution

1–2 FIFO

Units available for sale

• 100 @ £8
• 80 @ £9
• 70 @ £10
• Total units = 250

Units sold = 50 + 60 + 40 = 150
Closing units = 250 − 150 = 100 (matches the physical count)

FIFO cost of sales

Sale on 10 January: 50 units

• 50 from 3 Jan batch @ £8 = 50 × 8 =£400

Sale on 20 January: 60 units

• Remaining from 3 Jan batch: 100 − 50 = 50 units @ £8 → 50 × 8 =£400
• Balance needed: 10 units from 15 Jan batch @ £9 → 10 × 9 =£90
• Cost for this sale =£490

Sale on 30 January: 40 units

• From 15 Jan batch (after issuing 10 units): remaining 80 − 10 = 70 units @ £9
• Issue 40 @ £9 → 40 × 9 =£360

Total FIFO cost of sales
£400 + £490 + £360 = £1,250

FIFO closing inventory

After all sales, remaining inventory is:

• From 15 Jan batch: 70 − 40 =30 units @ £9→ 30 × 9 =£270
• From 25 Jan batch:70 units @ £10→ 70 × 10 =£700

Total FIFO closing inventory = £270 + £700 = £970

Check: £1,250 + £970 = £2,220 (matches total goods cost available for sale)

3–4 Periodic weighted average

Average cost per unit

Total units available = 100 + 80 + 70 = 250 units

Total cost =
(100 × £8) + (80 × £9) + (70 × £10)
= £800 + £720 + £700
= £2,220

Average cost per unit = £2,220 ÷ 250 = £8.88 (exact to 2 dp; in other questions, keep more decimals if the division does not terminate neatly)

Weighted average cost of sales

Units sold = 150
Cost of sales = 150 × £8.88 = £1,332

Weighted average closing inventory

Closing units = 100
Closing inventory = 100 × £8.88 = £888

Check: £1,332 + £888 = £2,220

5 Comparison and impact on the financial statements

Here prices rise over the month (£8 → £9 → £10). FIFO assigns more of the earlier, cheaper costs to sales, so:

• FIFO cost of sales is lower, givinghigher gross profit(all else equal).
• FIFO closing inventory is higher, because the remaining units are priced closer to the latest purchase costs.

Weighted average spreads the price changes across all units, producing results between the oldest and newest costs. This often leads to less volatility in gross profit and inventory values from period to period.

Common pitfalls and misunderstandings

• Batch allocation errors under FIFO:always issue from the oldest available batch and keep a running balance of units remaining in each layer.
• Confusing periodic and continuous records:in periodic questions, valuation is done at period end using total units and costs for the period.
• Including selling or distribution costs in inventory:routine delivery to customers is a selling expense, not part of inventory cost.
• Early rounding in weighted average:keep sufficient decimals during workings and round final figures as required.
• Not reconciling totals:always check that total cost available for sale equals cost of sales plus closing inventory.
• Incorrect treatment of abnormal losses:unusual wastage is expensed, not capitalised into inventory.
• Recoverable sales taxes misunderstood:where sales taxes on purchases are recoverable from the tax authority, they are treated as a receivable (or offset against the tax liability), not included in inventory cost.
• Returns handled inconsistently:returns affect the units and costs available and therefore affect FIFO layers or the weighted average cost.

Summary and further reading

FIFO and weighted average are widely used cost-flow methods for assigning purchase or production costs between cost of sales and closing inventory. FIFO tends to reflect the latest prices in closing inventory and, when prices rise, often results in higher gross profit than weighted average. Weighted average blends price changes across the period, reducing volatility.

Inventory is reported at the lower of cost and NRV. If NRV falls below cost, inventory is written down; if NRV subsequently improves, write-downs can be reversed, subject to the limit of the original write-down.

FAQ

Why can FIFO increase reported profit when prices are rising?

When purchase prices rise over time, FIFO allocates earlier (lower) costs to cost of sales first. Lower cost of sales means higher gross profit, assuming sales revenue is unchanged. The remaining inventory is then priced closer to the latest purchase costs, increasing the inventory asset.

How does weighted average reduce volatility in results?

Weighted average blends all purchase prices into a single cost per unit. This reduces the effect of sharp price movements on cost of sales and closing inventory, which can make gross profit and inventory balances more stable from one period to the next.

Which method produces the “best” inventory value?

Neither method is universally “best”. FIFO can make closing inventory closer to recent purchase prices, while weighted average produces a blended measure. The key is consistent application and clear, supportable workings.

How are write-downs and reversals tested in inventory questions?

You may be asked to compare cost with NRV item-by-item, or using a grouping approach, as instructed in the question and applied consistently. If NRV is lower, inventory is written down and the write-down is recognised as an expense. If NRV later increases, the write-down may be reversed, but only up to the original amount written down.

What checks should I do before finalising my numbers?

• Confirm: units purchased − units sold = units in closing count.
• Confirm: total cost available for sale = cost of sales + closing inventory.
• Confirm: included costs relate to acquiring/producing inventory and preparing it for sale (not selling or distribution).

Summary (Recap)

This chapter explained how FIFO and weighted average allocate costs between cost of sales and closing inventory. FIFO issues the earliest costs first and often increases gross profit when prices rise, while weighted average spreads price changes across all units. Inventory is then reported at the lower of cost and NRV, including write-downs when NRV is lower and permitted reversals when NRV improves, limited to the original write-down. The worked example demonstrated both methods under a periodic approach and reinforced key technique: disciplined layers/averages, careful rounding, and full reconciliation.

Glossary

FIFO (first in, first out)
A cost-flow method that assigns the earliest purchase or production costs to units sold first. Closing inventory is valued using the costs of the most recent unsold units.

Weighted average
A method that calculates an average cost per unit and applies it to units sold and units remaining. Under the periodic approach, one average is calculated for the entire period.

Cost of sales
The cost assigned to goods sold during the period. It is deducted from revenue to arrive at gross profit.

Closing inventory
Unsold goods at the reporting date, shown as an asset and measured using an inventory cost method, then compared with NRV for any necessary write-down.

Carriage inwards
Costs of bringing purchases into the business (freight-in/transport on purchases). Typically included in inventory cost.

Abnormal waste
Unusual losses beyond the level expected in normal operations. Treated as an expense rather than added to inventory cost.

Net realisable value (NRV)
What inventory is worth in a sale scenario at the reporting date: expected selling price less any remaining completion/preparation costs and less unavoidable selling costs needed to complete the sale.

Periodic inventory system
A system where purchases are recorded during the period and cost of sales is determined at period end using an inventory valuation adjustment.

Moving (perpetual) weighted average
A weighted average approach that updates the average cost per unit after each purchase as inventory records are maintained continuously.

Cost-flow assumption
A method used to assign costs to units sold and units remaining (for example FIFO or weighted average). It is an allocation method and may differ from the physical movement of goods.