Closing stock is often the largest figure in a trading business’s accounts after sales and purchases. The method used to value it decides how much of your purchase cost is treated as cost of goods sold this period, and therefore your profit.
Why the method matters
When you buy the same item at different prices, you have to decide which cost belongs to the units you sold and which to the units still in stock. Different methods give different answers, so the method should be chosen deliberately and then applied consistently.
The common methods
- First in, first out (FIFO): the oldest cost is used first, so closing stock carries the most recent purchase prices.
- Weighted average: each unit carries the average cost of the units available.
- Specific identification: each unit or lot carries its own actual cost. It suits items that are not interchangeable, such as distinct lots or individually identified goods.
A worked example
You buy 10 units at ₹100 and then 10 units at ₹120, a total of ₹2,200, and sell 12 units.
| FIFO | Weighted average | |
|---|---|---|
| Cost of the 12 units sold | ₹1,240 (10 × ₹100 + 2 × ₹120) | ₹1,320 (12 × ₹110) |
| Value of the 8 units left | ₹960 (8 × ₹120) | ₹880 (8 × ₹110) |
| Total | ₹2,200 | ₹2,200 |
What the accounting standards say
In India, the accounting standards on inventories (AS 2, or Ind AS 2 for companies that follow Ind AS) generally require inventory to be valued at the lower of cost and net realisable value, and allow FIFO or weighted average cost, with specific identification for items that are not ordinarily interchangeable. Your accountant will confirm what applies to your business.
Keep the inputs clean
- Enter purchase cost correctly, and decide which charges, such as freight, are part of it.
- Value opening stock carefully when you start; it carries into every later period.
- Record returns against the original purchase or sale, so the right cost comes back.
- Count stock regularly: a valuation of the wrong quantity is still wrong.
Common questions
Which inventory valuation method should I use?
Use the method your accountant recommends under the accounting standards that apply to you, and apply it consistently from one period to the next. FIFO and weighted average are the common choices for interchangeable goods.