Inventory valuation is the method a business uses to decide how much its inventory is worth in the accounts. Although the inventory itself does not change, different valuation methods can lead to very different profit figures, tax amounts, and balance sheet values.
Because of this, inventory valuation is not just an accounting formality. It directly affects how a business’s financial performance is reported and understood.
Why Inventory Valuation Matters?
Every business buys inventory and later sells it. The difference between what the inventory cost and what it sells for becomes profit. The challenge arises when the same product is bought at different prices over time.
The valuation method determines:
- How much cost is charged to sales (cost of goods sold)
- How much inventory remains on the balance sheet
- How much profit and tax the business reports
A simple change in method can increase or decrease reported profit even when sales stay the same.
Common Inventory Valuation Methods
1. First-In, First-Out (FIFO)
FIFO assumes that the oldest inventory is sold first.
Example
- Buy 100 units at $10
- Buy 100 units at $12
- Sell 150 units
Under FIFO:
- Cost of goods sold = (100 × 10) + (50 × 12) = $1,600
- Ending inventory = 50 × 12 = $600
What this means
FIFO usually shows higher profits when prices are rising because older, cheaper inventory is sold first. Ending inventory reflects recent purchase prices, which makes the balance sheet look more current.
FIFO works well for:
- Perishable goods
- Fashion or technology products
- Businesses where older stock is sold first in reality
2. Last-In, First-Out (LIFO)
LIFO assumes the most recent inventory is sold first.
Using the same example
Under LIFO:
- Cost of goods sold = (100 × 12) + (50 × 10) = $1,700
- Ending inventory = 50 × 10 = $500
What this means
LIFO results in higher costs and lower profits when prices rise, which can reduce taxes. However, LIFO is not allowed under international accounting standards (IFRS), only under U.S. GAAP.
LIFO is mainly used by:
- U.S. businesses
- Companies facing long-term price increases
3. Weighted Average Cost
This method calculates an average cost for all inventory items and applies it to every unit sold.
Example
- Total units = 150
- Total cost = $1,700
Average cost per unit = $11.33
If 150 units are sold:
- Cost of goods sold = 150 × 11.33 ≈ $1,700
What this means
Weighted average cost smooths price changes. Profits do not rise or fall sharply when costs change.
This method suits:
- Manufacturers of identical products
- Retailers with high-volume, similar inventory
- Businesses using modern accounting software
4. Specific Identification
Specific identification tracks the actual cost of each item sold.
Example
| Item | Cost | Selling Price |
|---|---|---|
| Watch A | $18,000 | $26,000 |
| Watch B | $25,000 | $32,000 |
Each sale uses the exact cost of that item.
What this means
This method is very accurate but only practical when items are unique and valuable.
Used by:
- Jewelry dealers
- Art sellers
- Custom equipment businesses
Simple Comparison of Methods
| Method | Profit in Rising Prices | Inventory Value | Complexity | IFRS Allowed |
|---|---|---|---|---|
| FIFO | Higher | Higher | Low | Yes |
| LIFO | Lower | Lower | High | No |
| Weighted Average | Moderate | Moderate | Low | Yes |
| Specific Identification | Exact | Exact | High | Yes |
Real Business Examples
Example 1: Seasonal Party Supply Store
Your situation:
- Buy ₹100 lakh in August before peak season (₹50/unit)
- Sell ₹80 lakh worth in Oct-Nov
- Prices rise to ₹60/unit for winter stock
| Method | COGS | Profit | Ending Value | Benefit |
|---|---|---|---|---|
| FIFO | ₹80L (old stock) | ₹20L | Higher (new stock @ ₹60) | Balance sheet realistic |
| WAC | ₹80L (mixed) | ₹20L | Medium | Smooths seasonal bulks |
Choice: Weighted Average. Smooths the impact of bulk August buying. Profit stays stable month-to-month for better pricing decisions.
Example 2: Tool Manufacturer
Your situation:
- Makes standardized products
- Steel prices fluctuate 8-12% annually
- Wants stable product margins
| Price Scenario | FIFO Profit | WAC Profit | LIFO Profit |
|---|---|---|---|
| Steel @ ₹50/kg | ₹100M | ₹100M | ₹100M |
| Steel @ ₹60/kg (20% up) | ₹130M | ₹110M | ₹90M |
| Volatility | ₹30M swing | ₹10M swing | ₹10M swing |
Choice: Weighted Average. Stable ₹110M profit despite material price swings. Enables consistent product pricing.
Example 3: Luxury Car Dealer
Your situation:
- Each car is unique (even same model)
- Different acquisition costs
- Need precise profit per sale
| Sale | Car Cost | Sell Price | Profit |
|---|---|---|---|
| Car A | ₹25L | ₹30L | ₹5L |
| Car B | ₹28L | ₹33L | ₹5L |
| Car C | ₹26L | ₹31L | ₹5L |
Choice: Specific Identification. Each car tracked individually. Auditors and lenders see exact profit per transaction.
Choosing the Right Method
The best method depends on the business, not on which method looks best on paper.
Consider:
- Type of inventory (perishable, unique, or identical)
- Price trends in your market
- Accounting rules you must follow
- System capability to support the method
- Tax impact, especially during inflation
Once chosen, the method should be used consistently. Changing it later requires explanation, disclosures, and sometimes restating past financial statements.
Key Takeaway
Inventory valuation affects profit, taxes, and financial position—even when sales stay the same. FIFO, LIFO, weighted average, and specific identification all have valid uses, but only in the right situations.
The goal is not to maximize profit on paper, but to choose a method that reflects how the business actually operates and produces reliable financial information.
A well-chosen inventory valuation method supports better decisions, clearer reporting, and fewer problems as the business grows.
