Finance · Accounting Fundamentals

Inventory Valuation: Methods, Formula and Practical Example

Inventory is often one of the largest current assets of a trading or manufacturing business. How inventory is valued affects the balance sheet, cost of goods sold, and reported profit.

1. What Is Inventory Valuation?

Inventory valuation is the process of determining the monetary value of inventory held by a business at a particular date.

Inventory may include raw materials, work in progress, and finished goods. For a trading business, it commonly consists of goods purchased for resale.

Inventory valuation is important because unsold inventory is generally reported as an asset, while the cost of inventory sold is recognised as an expense through Cost of Goods Sold.

2. Why Is Inventory Valuation Important?

• Balance sheet: Determines the value of inventory reported as a current asset.
• Profit measurement: Affects Cost of Goods Sold and gross profit.
• Purchasing decisions: Helps businesses understand the value of stock held.
• Stock control: Supports reconciliation between physical stock and accounting records.
• Financial reporting: Supports consistent application of the relevant accounting framework.

3. Common Inventory Valuation Methods

First In, First Out (FIFO)

FIFO assumes that inventory acquired or produced first is sold first. The cost of earlier inventory is assigned to Cost of Goods Sold first, while newer costs generally remain in ending inventory.

FIFO is commonly used in businesses dealing with products that have expiry dates or where older stock is generally sold before newer stock. The accounting cost-flow assumption does not necessarily have to match the physical movement of every item.

Weighted Average Cost

The weighted average method calculates an average cost per unit using the cost and quantity of inventory available.

Under a periodic system, the average is calculated for the relevant period. Under a perpetual system, a moving average may be recalculated after purchases.

Specific Identification

Specific identification assigns the actual cost of a particular item to that item. It is suitable for inventory items that are not ordinarily interchangeable, or for goods or services produced and segregated for specific projects where the applicable accounting rules permit it.

Examples may include individually identified vehicles, specialised equipment, or unique products.

Important: Under IFRS and Ind AS inventory rules, FIFO and weighted average are commonly permitted cost formulas for ordinarily interchangeable inventory. LIFO is not permitted under these frameworks. Applicable requirements depend on the accounting framework used by the business.

4. Practical Example: FIFO vs Weighted Average

Suppose a business purchases the following inventory during a period.

The business sells 150 units, leaving 50 units in ending inventory.

Calculation Using FIFO

Under FIFO, the first 100 units sold are costed at ₹100 per unit, and the next 50 units are costed at ₹120 per unit.

Cost of Goods Sold = (100 × ₹100) + (50 × ₹120) = ₹16,000.

The remaining 50 units come from the second purchase.

Ending Inventory = 50 × ₹120 = ₹6,000.

Calculation Using Weighted Average

Weighted Average Cost per Unit = ₹22,000 ÷ 200 = ₹110.

Cost of Goods Sold = 150 × ₹110 = ₹16,500.

Ending Inventory = 50 × ₹110 = ₹5,500.

Both methods allocate the same total cost of ₹22,000 between goods sold and goods remaining. They differ in how that cost is allocated.

5. How Inventory Valuation Affects Profit

When purchase costs increase, FIFO may produce lower Cost of Goods Sold and higher ending inventory than weighted average in a rising-cost scenario. The reverse may occur when costs are falling.

Using our example, assume the 150 units sold generate revenue of ₹30,000.

The valuation method changes the timing of cost recognition and therefore affects reported gross profit and ending inventory. It does not change the total cost of the inventory available in this example.

6. Inventory Valuation and Net Realisable Value

Under IFRS and Ind AS inventory requirements, inventory is generally measured at the lower of cost and net realisable value.

Net realisable value is the estimated ordinary-course selling price less estimated completion costs and the costs necessary to make the sale.

For example, if inventory has a recorded cost of ₹10,000 but its net realisable value falls to ₹8,000, the inventory may need to be written down to ₹8,000, subject to the applicable accounting requirements.

This protects financial statements from reporting inventory above the amount expected to be realised through sale.

7. Inventory Valuation Journal Entries

Under a perpetual inventory system, purchasing inventory on credit may be recorded as follows, assuming no indirect taxes or other adjustments.

When goods are sold, the business generally recognises revenue and the corresponding cost of inventory sold. The cost entry is illustrated below.

The cost entry uses ₹6,000 only as an illustration. The actual amount depends on the cost formula applied and the quantity sold.

8. Common Inventory Valuation Mistakes

Mistake 1: Treating purchase price as the only possible inventory cost.
Depending on the applicable accounting requirements, inventory cost may include purchase costs, conversion costs, and other costs incurred to bring inventory to its present location and condition.

Mistake 2: Ignoring obsolete or damaged inventory.
Stock that cannot be sold at its recorded cost may require a write-down.

Mistake 3: Changing valuation methods without proper justification.
Apply the relevant accounting framework consistently and document any permitted change in accounting policy.

Mistake 4: Ignoring physical stock differences.
Reconcile inventory records with physical counts and investigate shortages, damage, and recording errors.

Conclusion

Inventory valuation affects the value of stock on the balance sheet and the cost recognised in the income statement when goods are sold.

FIFO, weighted average, and specific identification may be appropriate in different circumstances, depending on the nature of inventory and the applicable accounting requirements.

Businesses should apply their chosen method consistently, reconcile inventory records, and review whether recorded costs remain recoverable.