Stock valuation: FIFO, LIFO and weighted average cost

40 min

Same sheets, three profits

In March, Isange Hardware bought iron sheets three times, each time at a higher price, and sold 350 of them. The sheets are identical: no one can say which sold sheet came from which delivery. Yet the cost of the sheets sold, and so the gross profit and the value of the 100 sheets left, depends on an assumption about which costs left first. This lesson works the same month three ways and asks which answer is "right".

Definition

Stock valuation: deciding the cost at which closing stock is recorded, and so the cost of goods sold. First in, first out (FIFO): issues are costed at the oldest prices, so closing stock is at the latest prices. Last in, first out (LIFO): issues are costed at the newest prices, so closing stock is at the oldest prices.

Definition

Weighted average cost (AVCO): issues and closing stock are valued at an average cost per unit. In a perpetual system the average is recalculated after every purchase:

\text{average cost per unit} = \frac{\text{value of stock on hand}}{\text{units on hand}}

In a periodic system one average is used for the whole period: total cost of goods available divided by total units available.

Definition

Net realisable value (NRV): the expected selling price less the costs of finishing and selling. The international standard on inventories, IAS 2, requires stock to be shown at the lower of cost and NRV, and does not allow LIFO.

Picturing the three methods

These are assumptions about costs, not about which physical sheet leaves the store. A shop can sell its oldest sheets first to avoid rust and still value its stock by AVCO.

Date (March)	Transaction	Sheets	Cost per sheet (Frw)
1	Opening stock	100	8,000
5	Purchase	200	8,500
12	Sale (at Frw 12,000)	180
18	Purchase	150	9,000
25	Sale (at Frw 12,500)	170

Goods available cost $800,000 + 1,700,000 + 1,350,000 = 3,850,000$ francs for 450 sheets; 350 are sold and 100 remain. Every method splits the Frw 3,850,000 between cost of goods sold and closing stock.

Worked example 1: FIFO (perpetual stores ledger)

Date	Received	Issued	Balance
1			100 × 8,000 = 800,000
5	200 × 8,500 = 1,700,000		100 × 8,000 + 200 × 8,500 = 2,500,000
12		100 × 8,000 + 80 × 8,500 = 1,480,000	120 × 8,500 = 1,020,000
18	150 × 9,000 = 1,350,000		120 × 8,500 + 150 × 9,000 = 2,370,000
25		120 × 8,500 + 50 × 9,000 = 1,470,000	100 × 9,000 = 900,000

FIFO: cost of goods sold $1,480,000 + 1,470,000 = 2,950,000$ ; closing stock Frw 900,000. Check: $2,950,000 + 900,000 = 3,850,000$ .

Worked example 2: LIFO and AVCO

LIFO. 12 March: issue 180 from the newest batch, $180 \times 8{,}500 = 1{,}530{,}000$ , leaving 100 × 8,000 and 20 × 8,500. 25 March: issue $150 \times 9{,}000 + 20 \times 8{,}500 = 1{,}350{,}000 + 170{,}000 = 1{,}520{,}000$ . Cost of goods sold Frw 3,050,000; closing stock $100 \times 8{,}000 = 800{,}000$ .

AVCO. After 5 March: $\frac{2{,}500{,}000}{300} \approx 8{,}333.33$ a sheet; the 180 issued cost $180 \times 8{,}333.33 = 1{,}500{,}000$ , leaving 120 sheets worth 1,000,000. After 18 March: $\frac{1{,}000{,}000 + 1{,}350{,}000}{270} \approx 8{,}703.70$ a sheet; the 170 issued cost about 1,479,630. Cost of goods sold about Frw 2,979,630; closing stock about $100 \times 8{,}703.70 = 870{,}370$ .

Worked example 3: comparing the results

Sales: $180 \times 12{,}000 + 170 \times 12{,}500 = 2{,}160{,}000 + 2{,}125{,}000 = 4{,}285{,}000$ francs.

Method	Cost of goods sold	Gross profit	Closing stock
FIFO	2,950,000	1,335,000	900,000
AVCO	2,979,630	1,305,370	870,370
LIFO	3,050,000	1,235,000	800,000

Analysis: when prices are rising, FIFO gives the highest closing stock and profit, because the cheap old costs are charged to sales and the dear new ones stay in stock. LIFO gives the lowest profit and an out-of-date stock value. AVCO lies between. Over the life of the business total profit is the same; the methods only move profit between periods, so a business must use the same method consistently.

Warning

Check NRV before you close the books. If 100 sheets carried at FIFO cost of Frw 9,000 are rusted and can be sold only for Frw 7,500 each after costs, they must be written down to NRV: a loss of $100 \times (9{,}000 - 7{,}500) = 150{,}000$ francs this period. Stock is never shown above what it can earn.

Accounting Stuff, "First In First Out (FIFO) | Inventory Cost Flows". Follow the layers of cost as units are sold, and compare them with Worked example 1.

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Practice

Explain FIFO, LIFO and AVCO in one sentence each.
Opening stock: 50 units at Frw 2,000. Purchases: 100 at Frw 2,200, then (after a sale of 120 units) 80 at Frw 2,500. A second sale is of 60 units. Using FIFO in a perpetual system, find the cost of each sale and the closing stock.
Repeat question 2 using LIFO.
Repeat question 2 using AVCO, recalculating the average after each purchase.
Show that each method's cost of goods sold plus closing stock equals the cost of goods available.
Prices of a business's stock are rising. Which method gives the highest profit, and why might the owner prefer a method that gives a lower one?
Explain why IAS 2 does not allow LIFO, and why stock is valued at the lower of cost and NRV.

Show answersHide answers

FIFO: issues are costed at the oldest prices. LIFO: issues are costed at the newest prices. AVCO: issues and stock are costed at an average cost per unit.
Sale 1: $50 \times 2{,}000 + 70 \times 2{,}200 = 254{,}000$ . Sale 2: $30 \times 2{,}200 + 30 \times 2{,}500 = 141{,}000$ . Closing stock $50 \times 2{,}500 = 125{,}000$ . COGS 395,000.
Sale 1: $100 \times 2{,}200 + 20 \times 2{,}000 = 260{,}000$ . Sale 2: $60 \times 2{,}500 = 150{,}000$ . Closing stock $30 \times 2{,}000 + 20 \times 2{,}500 = 110{,}000$ . COGS 410,000.
Average after first purchase $\frac{320{,}000}{150} \approx 2{,}133.33$ ; sale 1 costs 256,000, leaving 30 units worth 64,000. After second purchase $\frac{264{,}000}{110} = 2{,}400$ ; sale 2 costs 144,000. Closing stock $50 \times 2{,}400 = 120{,}000$ . COGS 400,000.
Goods available: $100,000 + 220,000 + 200,000 = 520,000$ . FIFO $395,000 + 125,000$ , LIFO $410,000 + 110,000$ , AVCO $400,000 + 120,000$ : all equal 520,000.
FIFO, because older, cheaper costs are charged to sales. An owner might prefer a lower reported profit to pay less income tax this year, or to avoid overstating profit when stock must be replaced at higher prices; but the method must be allowed and used consistently.
LIFO leaves stock valued at old, out-of-date prices and can be used to manage profit, so it does not give a faithful balance sheet. Valuing at the lower of cost and NRV is prudent: assets are not shown at more than they can bring in, and losses on damaged or obsolete stock are recognised at once.

1Same sheets, three profits

2Picturing the three methods

Same sheets, three profits

Picturing the three methods