Inventory Valuation: FIFO, LIFO, & WACC Methods Fully Explained

What is Inventory Valuation? (A BBA/MBA Guide)

Inventory valuation is the accounting method a company uses to find the monetary value of its closing stock (the inventory it has left at the end of an accounting period).

Why is this so important? Imagine you own a small shop.

• In January, you buy 100 pens at ₹10 each.

• In February, prices rise, and you buy 100 more pens at ₹12 each.

• In March, you sell 150 pens.

When you calculate your profit, which cost should you use for the pens you sold? The ₹10 ones? The ₹12 ones? A mix? Your choice will change your Cost of Goods Sold (COGS) and your final Net Profit.

The method you choose for valuing inventory is a key decision that impacts your company’s financial statements. Here are the 4 main methods used in accounting.

1. Specific Identification Method

This method tracks the exact cost of every single item in your inventory from the moment you buy it to the moment you sell it. Each item is individually identified.

• How it works: You know the specific cost of the exact item you sold.

• Best for: High-value, unique, and easily distinguishable items.

  • Examples: Cars (with a specific Vehicle Identification Number), custom jewelry, real estate, or large pieces of furniture.

• Benefits:

  • Perfectly Accurate: It’s the most accurate method, as the cost flow perfectly matches the actual physical flow of goods.

• Limitations:

  • Impractical: It is impossible for businesses with thousands of identical, low-cost items (like a grocery store or a pen manufacturer).

  • Easy to Manipulate Profit: A manager could choose to sell the “high-cost” item to show a lower profit, or the “low-cost” item to show a higher profit.

2. FIFO (First-In, First-Out) Method

This is the most common and logical method. It assumes that the First items to enter your inventory are the First ones to be sold.

Think of milk at a grocery store. The store sells the oldest milk first.

• What it means: The cost of the oldest items you purchased is used to calculate your COGS.

• Closing Stock Value: The items left in your closing stock are valued at the prices of the most recent purchases.

✅ Benefits of FIFO

• Logical: It matches the actual physical flow of most goods, especially perishable items.

• Accurate Balance Sheet: Your closing stock is valued at the most recent prices. This value is very close to the current market price, making your Balance Sheet’s “Current Assets” look accurate.

• Widely Accepted: This method is accepted by all major accounting standards, including IFRS and Ind AS.

• Prevents Spoilage: Following this flow in practice reduces losses from goods expiring or becoming obsolete.

❌ Limitations of FIFO

• Overstates Profit (During Inflation): This is the biggest drawback. When prices are rising (inflation), you are matching your old, cheap costs against your new, high sales prices. This makes your profit look artificially high.

• Higher Tax Bill: Because your reported profit is higher, your company will have to pay more in taxes.

• Complex Record-Keeping: You have to track every batch of inventory and its specific price, which can be difficult.

3. LIFO (Last-In, First-Out) Method

This method is the opposite of FIFO. It assumes that the Last items to enter your inventory (the newest ones) are the First ones to be sold.

Think of a stack of sandbags or coal. You always take the newest one off the top of the pile first.

• What it means: The cost of the most recent items you purchased is used to calculate your COGS.

• Closing Stock Value: The items left in your closing stock are valued at the prices of the oldest purchases.

✅ Benefits of LIFO

• Better Profit Matching (P&L): This is the main advantage. It matches your most recent (current) costs against your current sales revenue. In times of inflation, this gives a much more realistic picture of your profit.

• Tax Benefits (During Inflation): Because you are using your highest (most recent) costs, your COGS is higher, and your reported profit is lower. Lower profit means you pay less tax. This is the primary reason companies used this method.

❌ Limitations of LIFO

• Not Allowed by IFRS/Ind AS: This is a critical point for students. LIFO is banned by International Financial Reporting Standards (IFRS) and Indian Accounting Standards (Ind AS). It is still permitted in the U.S. (GAAP) but is not common globally.

• Inaccurate Balance Sheet: Your closing stock is valued at your oldest, most outdated costs. This can make your assets on the Balance Sheet look artificially low and misleading.

• Unrealistic Physical Flow: It does not match the actual physical flow of most products.

• Easy to Manipulate Profit: A manager can easily buy a large batch of high-cost inventory right before the year ends to intentionally lower the company’s profit and tax bill.

4. Weighted Average Cost (WAC) Method

This method finds a “middle ground” between FIFO and LIFO. It smooths out price fluctuations by calculating a new average cost for all items in your inventory every time you make a new purchase.

• How it works: All items (both sold and in stock) are valued at this one average price.

• Formula: WAC per unit = Total Cost of Goods Available for Sale / Total Units Available for Sale

✅ Benefits of WAC

• Simple & Logical: It is much easier to manage than tracking every single batch (like in FIFO/LIFO). There is just one average price for everything.

• Best for Indistinguishable Goods: This is the perfect method for products that are mixed together and cannot be separated, such as oil, gasoline, wheat, or iron ore.

• Smooths Out Prices: It avoids the extreme high profits of FIFO and the extreme low profits of LIFO, giving a more stable, middle-ground profit number.

• Widely Accepted: This method is allowed by both IFRS and Ind AS.

❌ Limitations of WAC

• Misleading Stock Value: The average cost of your closing stock might not reflect the actual current market price, which can make the Balance Sheet less accurate than FIFO.

• Constant Recalculation: If you use a perpetual inventory system, you must recalculate the new average cost after every single purchase, which can be a lot of work.

• Loses Batch Identity: It’s impossible to track the cost of specific batches, which can be a problem if the age or source of a product is important.

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