Inventory Valuation: FIFO, Weighted Average Cost and Net Realisable Value

For a trading or manufacturing business, inventory is often one of the largest assets on the balance sheet, and the cost of inventory sold is usually its largest expense. How inventory is valued therefore affects both profit and financial position directly. Under IFRS the rules are in IAS 2 Inventories.

The core rule is short: inventories are measured at the lower of cost and net realisable value. The detail is in what counts as cost, how cost is assigned to units sold and units remaining, and when a write-down is needed.

What is included in cost

The cost of inventory comprises all costs of purchase, costs of conversion and other costs incurred in bringing the items to their present location and condition.

Included	Excluded (expensed as incurred)
Purchase price, import duties and non-recoverable taxes	Abnormal waste of materials, labour or other costs
Transport and handling to bring goods to the warehouse	Storage costs, unless needed in production before a further stage
Direct labour and materials in production	Administrative overheads not related to production
Systematically allocated production overheads, based on normal capacity	Selling costs

Trade discounts and rebates are deducted from cost. Fixed production overheads are allocated on the basis of normal production capacity, so that a period of unusually low output does not inflate the cost of each unit.

Cost formulas: who left the shelf first?

When identical items are bought at different prices, the business needs a rule to decide which costs belong to units sold and which to units still held.

• Specific identification is required for items that are not interchangeable, such as custom-built machines or individual vehicles.
• For interchangeable items, IAS 2 allows first-in, first-out (FIFO) or weighted average cost.
• Last-in, first-out (LIFO) is not permitted under IFRS, although some other national frameworks allow it.

The same formula must be used for all inventories of a similar nature and use.

When purchase prices are rising, FIFO assigns older, cheaper costs to cost of sales, giving higher profit and a higher closing inventory figure than weighted average. When prices fall, the effect reverses. Over the life of the business the total cost recognised is the same; the formula changes the timing.

A business can apply weighted average either periodically (as above) or on a perpetual basis, recalculating the average after each purchase. Perpetual systems are common in modern inventory software.

Net realisable value and write-downs

Net realisable value (NRV) is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

Inventory may fall below cost because items are damaged, obsolete, out of fashion, or because selling prices have dropped. Example: 40 units of last season’s product cost 60 each. They can now be sold for 55 each, with selling costs of 7 per unit. NRV = 55 − 7 = 48 per unit, below cost. The write-down is 40 × (60 − 48) = 480, recognised as an expense in the period. If circumstances later improve, the write-down is reversed, but never above original cost.

Effect on the financial statements and ratios

• Gross profit and margin depend directly on cost of sales.
• Current ratio and working capital include inventory at its carrying amount.
• Inventory turnover and days in inventory, discussed in efficiency ratios, depend on both cost of sales and the inventory balance.
• Tax: in many countries the inventory method affects taxable profit; local rules apply.

Analysts comparing companies should check the cost formula in the accounting policy note and any write-downs disclosed, especially in sectors with volatile prices.

Practical controls

Inventory figures are only as reliable as the counts behind them. Good practice includes periodic physical counts reconciled to records, investigation of shrinkage, review of slow-moving items for NRV write-downs, and clear cut-off procedures so that goods received or dispatched around the year end are recorded in the right period. Inventory errors flow straight into profit: overstating closing inventory by 10,000 overstates profit by 10,000.

Common mistakes

• Including storage, selling or general administrative costs in inventory cost.
• Using LIFO when reporting under IFRS.
• Writing inventory up above cost when market prices rise.
• Ignoring slow-moving or damaged stock at the year end.
• Getting the cut-off wrong, so purchases and sales fall into different periods.