When you buy the same item at different prices over time, a question follows every sale: which cost did that unit carry? The answer sets your cost of sales, your gross profit and the value of the stock still on your shelves. The two most widely used methods are FIFO (first in, first out) and weighted average.
How each method works
FIFO assumes the oldest units are sold first. Cost of sales is taken from the earliest purchase layers, and the stock left over is valued at the most recent costs.
Weighted average blends the cost of everything available into one average. Each time stock is bought, the average is recalculated, and units are issued at that average cost.
The same facts, two results
Suppose a business buys 100 units at 10 each, then 100 more at 12 each, and then sells 120 units. The figures are illustrative.
| Measure | FIFO | Weighted average |
|---|---|---|
| Cost of sales (120 units) | 1,240 | 1,320 |
| Closing stock (80 units) | 960 | 880 |
| Total cost accounted for | 2,200 | 2,200 |
Here is the working. Under FIFO, the 120 units sold are the 100 bought at 10 plus 20 of those bought at 12, so cost of sales is 1,000 + 240 = 1,240. The 80 units left are all at 12, which gives 960. Under weighted average, the average cost is (1,000 + 1,200) ÷ 200 = 11 per unit. Cost of sales is 120 × 11 = 1,320 and closing stock is 80 × 11 = 880.
Both methods account for the same total cost of 2,200. They differ only in how that cost is split between the income statement and the balance sheet.
What this means when prices are rising
- FIFO gives a lower cost of sales, a higher profit and a higher stock value.
- Weighted average smooths price movements, so results sit between the extremes.
- When prices are falling, the effects reverse.
Neither method changes the cash you spent. It only changes when the cost reaches the profit and loss statement.
Choosing between them
- Nature of the stock. FIFO matches the physical flow for perishable or date-sensitive goods. Weighted average suits stock that is mixed together and interchangeable.
- Price volatility. If purchase prices swing widely, weighted average gives steadier margins.
- Record keeping. FIFO needs cost layers to be tracked. Weighted average needs the average recalculated on each receipt.
- Your reporting framework. This is often the deciding factor. IFRS (IAS 2) permits FIFO and weighted average for interchangeable inventory and does not permit LIFO. Other frameworks and tax rules differ, so confirm what applies to you.
Be consistent
Use the same costing method for inventory of a similar nature and use, and do not switch to improve a result. Changing a method is a change in accounting policy, which normally needs justification and disclosure. Agree the method with your accountant before you begin recording stock movements.
Do not forget the lower-of-cost rule
Whichever method you choose, inventory is generally carried at the lower of cost and net realisable value. If stock is damaged, obsolete or can only be sold below cost, write it down. A costing method decides cost, but it does not protect you from over-stating stock.