FIFO vs Weighted Average Cost: Inventory Costing Methods Compared With Examples

FIFO and weighted average are the two cost formulas IAS 2 allows for interchangeable inventory. FIFO (first in, first out) charges the oldest purchase prices to cost of goods sold and leaves the newest prices in closing stock. Weighted average charges every unit at the average cost of what is on hand. Total cost is the same; only the split between the income statement and the balance sheet changes.

This guide compares the two with one set of numbers, adds standard cost, specific identification and LIFO for context, explains periodic and perpetual (moving) averages, shows the effect on profit, tax and ratios, and ends with a decision checklist and how Ledgeriano's inventory module applies the method you choose.

#At a glance

#What is the difference between FIFO and weighted average cost?

FIFO assumes the units you bought first are the units you sell or consume first. Each purchase creates a cost layer (quantity and unit price), and issues eat through the layers from the oldest one. Closing stock is therefore made of the most recent layers.

Weighted average does not track layers. It divides the total cost of the units on hand by their quantity and charges every issue at that average. In a perpetual system the average is recalculated after every receipt, which is why it is also called a moving average. In a periodic system one average is computed for the whole period, after the fact.

Definition: A cost formula is the rule that assigns the cost of interchangeable inventory to the units sold and the units still on hand. IAS 2 names two for ordinary stock: first-in, first-out and weighted average cost.

Neither method has to match the physical flow of goods. A wholesaler can pick boxes from the front of the shelf and still value stock at weighted average. What matters is consistency and a result that represents cost fairly.

#Worked example: a tile distributor in a quarter of rising prices

A distributor of porcelain floor tiles sells one popular colour by the box. Prices from its supplier rose twice in the quarter. Amounts are in USD, and every box sells for 35.00.

Goods available for sale: 1,500 boxes costing 33,200. Sold: 1,300 boxes for 45,500. On hand at the end: 200 boxes.

#FIFO, step by step

1. 28 Jan sale (700 boxes). Take the whole 3 Jan layer (400 × 20.00 = 8,000) and 300 boxes of the 15 Jan layer (300 × 22.00 = 6,600). Cost: 14,600. Left: 300 at 22.00.
2. 10 Feb purchase. A new layer of 500 at 24.00.
3. 25 Feb sale (600 boxes). Take the remaining 300 at 22.00 (6,600) and 300 of the new layer at 24.00 (7,200). Cost: 13,800.
4. Closing stock. 200 boxes at 24.00 = 4,800.

Cost of goods sold: 14,600 + 13,800 = 28,400. Check: 28,400 + 4,800 = 33,200.

#Moving (perpetual) weighted average, step by step

1. After the two January purchases. 1,000 boxes costing 21,200, an average of 21.20.
2. 28 Jan sale. 700 × 21.20 = 14,840. Left: 300 boxes worth 6,360.
3. 10 Feb purchase. 300 + 500 = 800 boxes worth 6,360 + 12,000 = 18,360, a new average of 22.95.
4. 25 Feb sale. 600 × 22.95 = 13,770. Left: 200 boxes worth 4,590.

Cost of goods sold: 14,840 + 13,770 = 28,610. Check: 28,610 + 4,590 = 33,200.

#Periodic weighted average

A periodic system waits until the end of the quarter and divides goods available by units available: 33,200 ÷ 1,500 = 22.1333 per box. Cost of goods sold is 1,300 × 22.1333 = 28,773.33 and closing stock is 200 × 22.1333 = 4,426.67. The timing of sales inside the period does not matter, which is simple but means you only know your margin after the period closes.

#LIFO, for comparison only

LIFO (last in, first out) is shown here because US companies still meet it. With these figures, periodic and perpetual LIFO give the same answer: closing stock is the oldest 200 boxes at 20.00 (4,000) and cost of goods sold is 29,200. A company reporting under IFRS cannot use it.

#The four results side by side

When prices rise, FIFO reports the highest profit and the most current balance sheet value. Weighted average sits in between. LIFO reports the lowest profit and leaves old prices on the balance sheet. When prices fall, the order reverses.

#How does the choice affect tax and financial ratios?

The method changes when profit is recognised, not how much profit the business makes over its life. Once the last box is sold, every method has charged the same 33,200 to cost of goods sold. In between, the differences can be material.

Tax. Where taxable profit follows accounting profit, FIFO in a period of rising prices brings tax forward. In the example FIFO shows 800 more gross profit than LIFO; at the 21% US federal corporate rate that is 168 of tax paid earlier. Multiply by thousands of items and several years of inflation and the cash effect becomes the main reason some US companies still elect LIFO. Under the US LIFO conformity rule in section 472(c) of the Internal Revenue Code, a company that uses LIFO for tax must also use it in its reports to shareholders and lenders; the election is made on IRS Form 970. Tax rules differ by country, so confirm the treatment with your tax adviser before choosing.

Ratios. Lenders and analysts read margins and turnover, and both move with the cost formula:

FIFO flatters the balance sheet and the current ratio when prices rise; LIFO flatters turnover and depresses margins. When you compare two companies, check their inventory policy note before comparing margins.

#Standard cost: a third option for manufacturers and planners

Standard cost values every receipt and issue at a predetermined price per unit. IAS 2.21 accepts it when the result approximates actual cost and the standards are reviewed regularly. The difference between the price paid and the standard is recorded as a purchase price variance when the goods arrive.

Suppose the distributor set a standard of 22.00 a box for the quarter:

Cost of goods sold at standard is 1,300 × 22.00 = 28,600, and closing stock is 200 × 22.00 = 4,400. With the 200 net variance expensed, total cost is again 33,200. Notice that closing stock at standard (4,400) is 400 below FIFO (4,800) because the standard has fallen behind the market. That is the signal to revise the standard, or to allocate part of the variance to stock so the balance sheet stays close to cost.

#When must you use specific identification?

IAS 2.23 requires specific identification for items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects. Each unit carries its own actual cost. Typical cases are vehicles with chassis numbers, industrial machines, artworks, jewellery and custom-built orders. For ordinary interchangeable stock such as our tiles, specific identification is not appropriate, because picking which box to ship would let management pick the profit.

#Why is LIFO prohibited under IFRS?

The IASB removed LIFO when it revised IAS 2 in 2003. Its reasoning, set out in the basis for conclusions, is that LIFO does not faithfully represent inventory flows and can leave balance sheet values years out of date. US GAAP never followed: ASC 330 still lists LIFO as an acceptable method, largely because of its tax advantages for US companies. This is one of the best known differences between IFRS and US GAAP.

#Net realisable value: the ceiling on every method

Whatever the cost formula, inventory cannot stay on the balance sheet above what it will recover. IAS 2.9 measures inventory at the lower of cost and net realisable value (NRV): the estimated selling price less the estimated costs of completion and the costs to make the sale (IAS 2.6).

At the end of March the distributor learns the colour is being discontinued. The 200 boxes on hand cost 4,800 under FIFO. The expected clearance price is 25.00 a box and selling costs are 3.00, so NRV is 22.00 a box, or 4,400. The write-down is 400: debit inventory write-down expense (or cost of sales), credit inventory.

If a retailer agrees in May to take the remaining boxes at 30.00, under IFRS the 400 write-down is reversed (but never above the original cost of 4,800). Under US GAAP it stays.

#Can you change from FIFO to weighted average?

You can, but it is a change in accounting policy under IAS 8, allowed only when the new policy gives reliable and more relevant information. The change is applied retrospectively: comparative figures are restated as if the new formula had always been used, and the notes explain the reason and the effect. IAS 2.25 and 2.26 add that items of a similar nature and use must share one formula, so you cannot run FIFO for the tiles in one warehouse and average cost for the same tiles in another.

Changing methods to manage profit from year to year is exactly what the consistency rule prevents. Make the choice deliberately when an item is first set up.

#How to choose a cost formula

Use this checklist when you create items or a new category:

1. Are the units interchangeable? If not, use specific identification.
2. Do prices move a lot? Weighted average smooths spikes; FIFO keeps the balance sheet current.
3. Do you need batch or expiry control? FIFO cost layers sit naturally next to lot tracking, and you can still pick by expiry (FEFO) under either formula.
4. Do you plan with standards? Manufacturers that run variance analysis often value materials at standard cost and review the standards each quarter.
5. What do your peers use? Comparable margins help with lenders and buyers.
6. What does your tax law allow? In the US, LIFO is a tax election with conformity strings attached; elsewhere it is usually not available at all.
7. Can your system do it reliably? FIFO needs layers per item and location; moving average needs a recalculation after every receipt. Both need receipts posted before the issues that follow them.

#Why posting order matters in a perpetual system

Both FIFO and moving average depend on the order of movements. If a receipt dated 10 February is entered after the 25 February sale, the sale was costed without it. Under FIFO it would have consumed different layers; under moving average it would have used a different average. Good systems either refuse back-dated movements or re-cost everything after them and record the adjustment. This is also why month-end stock counts belong on the month-end close checklist.

#How Ledgeriano applies FIFO, weighted average and standard cost

Ledgeriano's inventory and cost accounting module is optional and switched on per business. It values stock with the formula you set on each item:

• Methods. FIFO, moving (perpetual) weighted average and standard cost, calculated per item and per warehouse. Items tracked by lot or serial number can use specific identification. LIFO is not offered, in line with IAS 2. A category can carry a default method for new items.
• Consistency built in. The valuation method and unit of an item cannot be changed after its first stock movement, so a change of formula is a deliberate decision, not an accident.
• Strict date order. By default a movement cannot be posted with a date earlier than the latest posted movement of the same item in the same warehouse, and stock can never go negative. FIFO layers and averages are therefore exact and reproducible.
• Optional re-costing. With the back-dated posting setting turned on, a back-dated document rewinds the later movements and replays them in date order: FIFO layers are rebuilt, averages are recomputed and standard costs stay unchanged. Every document whose value changes gets a cost adjustment entry dated on that document.
• Standard cost. Receipts and issues move at the item's standard cost, and the difference from the purchase price goes to a purchase price variance account.
• NRV and counts. Write-downs to net realisable value and landed costs are value-only stock documents. Physical counts create the adjustment for you.
• Ledger link. Every posted stock document creates a balanced journal entry, and a reconciliation report proves the stock ledger agrees with the general ledger. Reports include stock on hand, the item card (kardex) with running quantity and value, the movement summary and stock ageing by FIFO layer.

Everything is in the dashboard and in the accounting API. The inventory valuation and cost accounting guide goes on to job and process costing, and the glossary defines the terms used here.

#Common mistakes with inventory cost formulas

1. Mixing formulas for similar items. IAS 2.26 requires one formula for inventories of a similar nature and use.
2. Forgetting NRV. A cost formula sets cost; it does not test recoverability. Review slow and discontinued lines every quarter.
3. Letting standards go stale. A standard set a year ago can push stock far from actual cost.
4. Posting receipts late. In a perpetual system the order of movements changes the cost of every later issue.
5. Treating LIFO as an option under IFRS. It is not, and a group with US and IFRS reporting entities needs a conversion for consolidation.
6. Ignoring landed costs. Freight and duty belong in the cost of the goods, whatever formula you use.