The three common inventory valuation methods are FIFO (first in, first out), LIFO (last in, first out) and weighted average cost. They differ only in which purchase cost they assign to the units you sold, but that choice changes both your reported cost of goods sold and the value of the stock left on the shelf. When purchase prices are stable the three methods agree; when prices move, they diverge, and the gap can be material.
A worked example
Suppose you buy 100 units at 10 each, then another 100 units at 14 each, and then sell 120 units. Under FIFO, the 120 sold consist of the 100 cheap units plus 20 expensive ones, giving a cost of goods sold of 1,280 and closing stock of 1,120. Under LIFO, the 120 sold are the 100 expensive units plus 20 cheap ones, giving a cost of 1,600 and closing stock of 800. Under weighted average, the average cost is 12, so the cost is 1,440 and closing stock is 960. Identical physical stock, three different answers, and a 320 swing in reported profit.
- FIFO: cost of goods sold 1,280, closing stock 1,120
- LIFO: cost of goods sold 1,600, closing stock 800
- Weighted average: cost of goods sold 1,440, closing stock 960
- Same units, up to 320 difference in reported profit
FIFO: first in, first out
FIFO assumes the oldest stock sells first, which is usually what physically happens, especially with anything perishable or dated. When prices are rising it charges the older, cheaper costs against sales, which reports a higher profit and values closing stock closer to current replacement cost. That balance-sheet realism is why FIFO is the most widely accepted method, and it is permitted essentially everywhere.
- Matches the physical flow of most inventory
- Closing stock is valued near current cost
- Reports higher profit when purchase prices rise
- Accepted under both IFRS and US GAAP
LIFO: last in, first out
LIFO assumes the newest stock sells first. It rarely matches physical reality, but in a rising-price environment it charges current costs against current revenue, which some argue reflects economics more honestly and which reduces reported profit and therefore tax. The cost is a balance sheet carrying stock at old, understated values. Note that LIFO is prohibited under IFRS and permitted under US GAAP, so it is not available to most businesses outside the United States.
- Charges current costs against current revenue
- Reduces reported profit when prices are rising
- Understates closing stock value on the balance sheet
- Prohibited under IFRS; allowed under US GAAP
Weighted average cost
Weighted average pools the cost of all available units and charges the average against each sale. It is the simplest to operate at volume, it smooths out price volatility rather than letting it swing profit between periods, and it does not require tracking which specific batch a unit came from. For businesses handling thousands of interchangeable lines, this practicality usually outweighs the theoretical appeal of FIFO.
- Simplest to run at high transaction volume
- Smooths the profit effect of price volatility
- No need to track individual batch costs
- Accepted under both IFRS and US GAAP
Choosing, and then staying put
Pick FIFO if your stock is perishable or dated and you want a realistic balance sheet. Pick weighted average if you carry large numbers of interchangeable items and want operational simplicity. Only consider LIFO if you are in a US-reporting entity with genuinely rising costs and have taken tax advice. Whichever you choose, apply it consistently: switching methods changes reported profit without anything real having happened, so accounting standards require disclosure and auditors will ask.
- FIFO for perishable, dated or traceable stock
- Weighted average for large interchangeable catalogues
- LIFO only with US reporting and tax advice
- Apply consistently; changes need disclosure
Where valuation quietly breaks
The method matters far less than the data underneath it. If wastage is not recorded, if returns are entered on one side only, or if the physical count has not been reconciled in months, then every method produces a confident wrong answer. Recording stock additions, returns and adjustments as proper entries with movement history is what makes any valuation meaningful.
- Unrecorded wastage inflates stock value
- One-sided returns break both stock and margin
- Unreconciled counts make the method irrelevant
- Movement history is what lets you trace a discrepancy
FAQs
What are the main inventory valuation methods?
FIFO (first in, first out), LIFO (last in, first out) and weighted average cost. They differ in which purchase cost is assigned to units sold, which changes both reported cost of goods sold and the value of closing stock.
Which inventory valuation method should I use?
FIFO if your stock is perishable, dated or individually traceable, because it matches physical flow and values closing stock near current cost. Weighted average if you carry many interchangeable lines and want simplicity at volume. LIFO only applies to US-reporting entities and needs tax advice.
Is LIFO allowed?
It is permitted under US GAAP but prohibited under IFRS, so most businesses outside the United States cannot use it for financial reporting.
How does inventory valuation affect profit?
Directly. In the worked example above, the same 120 units sold produce a cost of goods sold of 1,280 under FIFO, 1,600 under LIFO and 1,440 under weighted average, which is a 320 swing in reported profit with no change in physical activity.
Can I change inventory valuation methods?
Only with good reason and proper disclosure. A change alters reported profit without any real economic event, so accounting standards require you to explain it and auditors will scrutinise it. Consistency is the expectation.