Inventory valuation: FIFO, weighted average, and what "cost" includes
Closing stock is the only number that sits in both your P&L and your balance sheet — value it wrong and you have misstated profit and net worth in one stroke. Yet most small businesses value stock by habit ("whatever the software did") without ever choosing a method. Here is what the choice actually is, and where the rupees move.
The two permitted methods
Indian accounting standards (AS 2 / Ind AS 2) allow FIFO and weighted average. LIFO is not permitted — a business "using LIFO" in India is using an error.
| Method | How it thinks | Behaviour when prices rise |
|---|---|---|
| FIFO (first in, first out) | The oldest purchase is deemed sold first; closing stock carries the newest costs | Higher closing stock → higher profit shown → more tax now. Mirrors physical flow for perishables and batch-tracked goods. |
| Weighted average | Every unit carries the running average cost of what's on hand | Smooths price spikes; profit reacts slower to purchase-price swings. Suits commodities bought at fluctuating rates. |
Both are correct; what matters is consistency — pick one, apply it to a class of inventory, and change it only with a reason you would happily explain to an auditor, with the change's effect disclosed.
What belongs in "cost" (and what must stay out)
- In: the purchase price, non-recoverable duties and taxes, freight inward, loading, insurance in transit — everything spent bringing the stock to its present location and condition. For manufactured goods: materials, direct labour, and a systematic share of production overheads.
- Out: GST you claim as ITC — a recoverable tax is not a cost, and stock valued GST-inclusive while the credit is also claimed is counted twice. Also out: selling costs, storage after production, abnormal wastage, and interest (for typical inventories).
- Trade discounts and rebates reduce cost; cash discounts for early payment are a finance item, not a stock item.
The NRV rule: stock is valued at the lower number
The standard says lower of cost and net realisable value — NRV being what the stock will actually sell for, minus the costs of selling it. Dead stock, damaged goods, last season's designs, expired batches: if they will fetch less than they cost, the books must say so now, not when they are finally thrown away. A godown full of stock "at cost" that nobody will buy is the balance sheet's most comfortable lie.
Remember the GST echo: stock written off or destroyed requires the ITC claimed on it to be reversed — valuation decisions and GST decisions travel together.
Why the number moves profit
Cost of goods sold = opening stock + purchases − closing stock. Every rupee added to closing stock is a rupee removed from this year's expenses — profit rises, tax rises, and next year inherits the higher opening. Valuation does not create or destroy profit; it times it. Which is exactly why tax officers read it: an unexplained method change or a quietly deflated year-end value is profit being moved between years.
The year-end count
- Count physically, at least annually — books record what should be there; the count finds what is.
- Investigate differences before adjusting them. A shortage can be theft, spoilage, an unbilled delivery or a data-entry slip — each has a different fix (and a different GST consequence).
- Value the counted stock by your method, apply NRV item-class-wise, and let the adjusted figure flow to the P&L.
- Keep the working papers — the count sheets and the valuation basis are the first ask in any assessment of a stock-carrying business.
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