Inventory Valuation: FIFO, LIFO and Average Cost

Materials are bought at different prices on different days, but they go into the stores as one pile. When some are issued to production, which price should be charged? The answer changes the cost of production, the profit for the period and the value of stock left over.

This topic explains the rule for valuing inventory at the year end, the three methods for pricing issues (FIFO, weighted average and last in, first out (LIFO)), and how each behaves when prices rise or fall.

This is one of the most heavily examined topics in the paper. It appears nearly every diet as a stores ledger question worth 15 to 20 marks, usually asking for two methods side by side, and often followed by a profit or gross profit calculation.

This page gives a fully laid-out method, three complete ledgers on one data set, a second data set for practice, and the arguments needed for the discussion parts.

The basic rule: lower of cost and NRV

Inventory affects cost of sales, gross profit and the value of current assets, so how it is valued matters. Under accepted accounting principles and the international standard on inventories (IAS 2), inventory is stated at the lower of historical cost and net realisable value.

• Historical cost is what it cost to bring the item to its present location and condition: the purchase price, import duties, transport, handling and other directly attributable costs.
• Net realisable value (NRV) is the amount the item can be sold for in the normal course of business, less any further costs of getting it ready for sale or of selling it.

NRV is normally higher than cost, so inventory is usually valued at cost. But if inventory is damaged or has become obsolete, NRV may fall below cost, and then NRV is used. The comparison is made for each separate item, or for groups of similar items, and not for inventory as a whole. Otherwise a profit on one line would hide a loss on another.

Worked illustration

NRV = selling price − selling costs − any cost still to be incurred. For S: ₦5,800 − ₦1,000 − ₦400 = ₦4,400. Items Q and S are written down. P and R stay at cost. If the comparison were made on the total (cost ₦33,700 against total NRV of ₦36,600), no write-down would appear, which would be wrong.

Cost flow methods: the three assumptions

When identical units are bought at different prices, the business needs a rule for the cost of units issued and for the units left. Three acceptable assumptions are used.

LIFO is not allowed under International Financial Reporting Standards (IFRS) for financial reporting, though it is still allowed under United States (US) accounting rules. It may be used in cost accounting, which is not governed by reporting standards. FIFO and weighted average can be applied in a perpetual system (updating after every movement) or a periodic system (valuing closing stock at the end of the period).

How to lay out a stores ledger

1. Use columns for date, receipts (quantity, unit price, value), issues (quantity, unit price, value) and balance (quantity, unit price, value). Where the balance has layers, list each layer on its own line.
2. Enter every transaction in date order.
3. For each issue, take units from layers in the order the method requires, splitting an issue across layers where necessary.
4. After every line, update the balance.
5. At the end, check: opening stock + receipts − issues = closing stock in both units and naira.

One data set, three methods

FIFO

FIFO: cost of issues = ₦12,400 + ₦20,000 + ₦17,000 = ₦49,400. Closing stock = ₦15,000 (300 units at the latest price of ₦50). Check: ₦49,400 + ₦15,000 = ₦64,400. ✓

LIFO

LIFO: cost of issues = ₦13,200 + ₦21,000 + ₦17,500 = ₦51,700. Closing stock = ₦12,700, made of the oldest layers. Check: ₦51,700 + ₦12,700 = ₦64,400. ✓

Weighted average (moving average after each receipt)

Weighted average: cost of issues = ₦12,857 + ₦20,278 + ₦16,835 = about ₦49,970. Closing stock = about ₦14,430. Check: ₦49,970 + ₦14,430 = ₦64,400. ✓ (Because of rounding, your own figures may differ by a naira or two. Keep unit averages to at least three decimal places in the working.)

The formula for the new average after a purchase is: (cost of stock already held + cost of the new purchase) ÷ (units held + units bought). A moving average is recalculated only when stock is received. Issues do not change the average, they simply remove units at the current average cost.

Periodic weighted average (one average for the whole period)

If the firm calculates a single average at the end of the period, the average is total cost available ÷ total units available = ₦64,400 ÷ 1,400 = ₦46 per unit. Issues of 1,100 units cost ₦50,600 and closing stock of 300 units is ₦13,800. This is a simpler variant, but it cannot give a running balance after each issue.

Comparing the methods

Prices rose from ₦40 to ₦50 over the month, and the pattern is the typical one for rising prices:

• FIFO charges old, cheaper costs to issues, so cost of sales is lowest, profit is highest, and closing stock is closest to current replacement cost.
• LIFO charges the newest, dearer costs to issues, so cost of sales is highest, profit is lowest, and closing stock is stated at old prices, well below current cost.
• Weighted average lies between the two, because it blends all prices.

When prices fall, everything reverses: FIFO shows the highest cost of issues and the lowest closing stock. Notice that for the same data, the three methods always give total issues plus closing stock of the same ₦64,400. They differ only in how that total is divided. Over the whole life of the business the total profit is the same. The methods only change when profit is recognised.

Merits and demerits

The ideas in more depth

Why the choice matters

The method chosen affects cost of materials in production, reported profit, the value of stock in the statement of financial position, and, through profit, the tax paid. A cost accountant should pick a method that fits the business, apply it consistently, and understand how it will affect reported results. Switching methods from year to year makes results incomparable.

FIFO versus LIFO in inflation, in one sentence each

FIFO: the stock on the shelf is valued at recent prices, but the cost charged against sales is out of date, so profit looks high. LIFO: the cost charged against sales is current, so profit is realistic, but the stock on the shelf is valued at prices from long ago.

Choosing between perpetual and periodic

FIFO gives the same closing stock value in a perpetual or a periodic system, because it always leaves the latest purchases in stock. LIFO and moving-average results differ between the two systems, because the issue prices depend on what was in stock at the time of each issue. Check which system the question describes.

Effect on an operating statement

Exam questions often continue: “prepare an operating statement assuming a selling price of ₦X per unit under the two methods”. Do this: sales = units sold × price; less cost of issues (from the ledger); gross profit. Add other expenses if given. The difference in profit between methods equals the difference in cost of issues, which is also the difference in closing stock values in the opposite direction.

Worked example: a full question

Total cost available: ₦5,000 + ₦22,000 + ₦18,000 + ₦13,000 = ₦58,000. Closing units = 100 + 400 − 300 + 300 − 350 + 200 = 350.

1. FIFO.
   9 June: 100 @ 50 + 200 @ 55 = ₦5,000 + ₦11,000 = ₦16,000.
   Balance 200 @ 55.
   After 14 June: 200 @ 55 + 300 @ 60.
   20 June: 200 @ 55 + 150 @ 60 = ₦11,000 + ₦9,000 = ₦20,000.
   Balance 150 @ 60.
   After 27 June: 150 @ 60 + 200 @ 65 = ₦9,000 + ₦13,000 = ₦22,000.
   Issues ₦36,000; closing stock ₦22,000. Check: ₦36,000 + ₦22,000 = ₦58,000.
2. LIFO.
   9 June: 300 @ 55 = ₦16,500.
   Balance 100 @ 50 + 100 @ 55.
   After 14 June: add 300 @ 60.
   20 June: 300 @ 60 + 50 @ 55 = ₦18,000 + ₦2,750 = ₦20,750.
   Balance 100 @ 50 + 50 @ 55 = ₦7,750.
   After 27 June: add 200 @ 65 = ₦13,000, so closing = ₦20,750.
   Issues ₦37,250; closing stock ₦20,750. Check: ₦37,250 + ₦20,750 = ₦58,000.
3. Weighted average.
   After 6 June: ₦27,000 ÷ 500 = ₦54.00.
   9 June issue: 300 × 54 = ₦16,200; balance 200 units, ₦10,800.
   After 14 June: (₦10,800 + ₦18,000) ÷ 500 = ₦57.60.
   20 June issue: 350 × 57.60 = ₦20,160; balance 150 units, ₦8,640.
   After 27 June: (₦8,640 + ₦13,000) ÷ 350 = ₦61.829.
   Issues ₦36,360; closing stock ₦21,640. Check: ₦36,360 + ₦21,640 = ₦58,000.
4. Observation. Prices rose each time, so FIFO shows the lowest issues (₦36,000) and the highest stock (₦22,000), LIFO the highest issues (₦37,250) and the lowest stock (₦20,750), with average in between.

Perpetual and periodic systems compared

The stores ledgers earlier updated the balance after every receipt and issue (a perpetual system). In a periodic system, the cost of issues is found only at the end of the period from opening stock, purchases and a count of closing stock. FIFO gives the same figures in both systems. LIFO and the weighted average do not. Using item Z (total cost available ₦64,400; closing stock 300 units):

The periodic LIFO treats all purchases of the month as if they came before any issue, so issues are charged at the latest prices of the whole month, while the perpetual version uses the stock actually on hand at the time of each issue. Always check which system the question describes.

The effect of the method on profit and tax

When prices rise, the choice of method moves profit by thousands of naira, and if profit is taxed, tax too. With sales of 1,100 units at ₦70 (₦77,000) and tax at 30% of the gross profit, the effect on the item’s tax is:

LIFO would save ₦690 of tax against FIFO on this single item while prices rise, which is one reason why some countries permit it for tax. Since the total cost is the same (₦64,400), the tax saved is only deferred: it comes back when stock is sold or prices fall. This is why LIFO is not allowed for financial reporting under IFRS, as it understates stock and distorts profit.

Other cost formulas permitted by IAS 2

Background: the syllabus deals with FIFO, LIFO and weighted average. IAS 2 also allows two practical techniques.

• Standard cost method: stock is valued at the standard cost per unit, provided the standards approximate actual cost and are reviewed regularly. Differences between actual and standard are variances.
• Retail method: used in shops with many lines at changing prices. Closing stock at selling price is reduced by the average gross margin to approximate cost.
  If closing stock at retail value is ₦500,000 and the gross margin is 30%, cost = ₦500,000 × 70% = ₦350,000.

A stores ledger layout to copy

Use one row for each transaction, write each layer on its own line, and cross-check the totals at the end: opening + receipts − issues = closing.

Choosing a method in practice

Common mistakes in the exam

• Taking a LIFO issue from the oldest layer, or a FIFO issue from the newest. Re-read the rule before each issue.
• Forgetting to split an issue across two layers when the first layer runs out.
• Recalculating the weighted average after an issue. A moving average changes only on receipts.
• Rounding the average unit cost too early (for example to the nearest naira), which makes the totals fail the check.
• Not showing the balance after each transaction when the question asks for daily balances as a memo.
• Not checking that issues plus closing stock equals opening stock plus all receipts.
• Applying the lower of cost and NRV to the total of all stock instead of item by item.
• Saying that LIFO is permitted under IFRS. It is not, though it may be used in internal cost accounts.
• Giving an advantage of FIFO without saying that it lowers cost of sales when prices rise.

Quick revision

• Value at the lower of cost and NRV, item by item. NRV = selling price − selling costs − completion costs.
• FIFO: oldest out first, closing at latest prices. LIFO: newest out first, closing at oldest prices. WAVCO: average recalculated after each receipt.
• Rising prices: FIFO lowest cost of sales and highest profit and stock. LIFO the opposite. Average in between. Falling prices: reverse.
• Opening stock + receipts = issues + closing stock. Use this to check.
• LIFO is not allowed under IFRS but may be used in cost accounting.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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