Inventory and Cost of Goods Sold: Valuing What You Sell

For businesses that sell physical products, inventory is often the largest asset on the balance sheet. The method used to value inventory directly affects reported profit — making this one of the most consequential accounting choices a business makes.

What Counts as Inventory Cost?

Inventory cost includes all costs necessary to bring the goods to their present condition and location: purchase price, import duties, freight charges, and handling costs. Trade discounts are deducted; general selling expenses are not included.

Inventory Valuation Methods

1. FIFO (First-In, First-Out)

Assumes the oldest inventory is sold first. In a period of rising prices, FIFO produces a lower COGS (older, cheaper costs are expensed first) and a higher closing inventory value. This results in higher reported profit but higher tax.

2. LIFO (Last-In, First-Out)

Assumes the newest inventory is sold first. In rising prices, LIFO produces higher COGS (recent, dearer costs expensed first) and lower reported profit — reducing tax. Note: LIFO is not permitted under IFRS/Ind AS, only under US GAAP.

3. Weighted Average Cost

Calculates a new average cost after each purchase. All units (whether sold or remaining) carry the same average cost. Produces results between FIFO and LIFO. Commonly used in the US under Ind AS.

Numerical Example

Purchases: 100 units @ $100 = $10,000; then 100 units @ $120 = $12,000. Sold 150 units.

FIFO COGS: 100 × $100 + 50 × $120 = $16,000. Closing inventory: 50 × $120 = $6,000.
LIFO COGS: 100 × $120 + 50 × $100 = $17,000. Closing inventory: 50 × $100 = $5,000.
Avg Cost: ($22,000 ÷ 200) = $110/unit. COGS: 150 × $110 = $16,500. Closing: 50 × $110 = $5,500.

Perpetual vs. Periodic Inventory Systems

Under the perpetual system, inventory records are updated after every purchase and sale (standard in modern businesses with POS systems). Under the periodic system, inventory is physically counted at period end and COGS is calculated as: Opening Inventory + Purchases − Closing Inventory.

Lower of Cost or Net Realisable Value (LCNRV)

Under Ind AS 2, inventory must be measured at the lower of cost or net realisable value (NRV). If market prices drop below cost, the inventory is written down to NRV — applying the conservatism principle.

Lesson Summary

• FIFO, LIFO (US GAAP only), and weighted average are the main inventory valuation methods.
• The choice of method affects COGS, profit, tax, and balance sheet inventory value.
• Inventory must be recorded at the lower of cost or net realisable value.

Inventory Costing Methods — Side-by-Side Comparison

When prices change over time, the inventory method chosen has a direct impact on COGS, gross profit, and taxes. Consider a retailer who purchased 300 units at varying costs and sold 200 units:

Key takeaway: In a period of rising prices, LIFO gives the highest COGS, lowest profit, and lowest tax bill. FIFO gives the most realistic ending inventory value. The US (GAAP) allows all three; IFRS prohibits LIFO.

Journal Entries for Inventory Transactions