Valuation of Stock: LIFO, FIFO, HIFO and Weighted Average Method
Valuation of Stock: LIFO, FIFO, HIFO, and Weighted Average Method
Valuing stock (inventory) accurately is crucial for businesses to determine the cost of goods sold (COGS), gross profit, and overall financial position. Different methods are used to value stock, each with its advantages and implications for financial reporting. The most common methods are LIFO (Last In, First Out), FIFO (First In, First Out), HIFO (Highest In, First Out), and the Weighted Average Method.
1. FIFO (First In, First Out)
FIFO assumes that the first goods purchased (or produced) are the first to be sold or used. This method values the closing stock based on the most recent purchases, as older inventory is sold first.
Key Features of FIFO
- First items purchased are sold first.
- The closing stock consists of the most recently purchased goods.
- Ideal for businesses where goods are perishable (e.g., food, pharmaceuticals).
Impact on Financial Statements
- During inflation: FIFO results in lower COGS and higher profits because older, cheaper inventory is used to calculate COGS, and more expensive, newer inventory remains in stock.
- Closing Stock Value: The closing stock is valued at the most recent purchase prices, which generally reflects the current market value.
Example:
- Purchase 1: 100 units @ ₹50 = ₹5,000
- Purchase 2: 100 units @ ₹60 = ₹6,000
- Sale: 150 units
- Under FIFO, 100 units from the first purchase at ₹50 and 50 units from the second purchase at ₹60 are sold.
COGS = (100 * ₹50) + (50 * ₹60) = ₹5,000 + ₹3,000 = ₹8,000
Closing Stock = 50 units * ₹60 = ₹3,000
2. LIFO (Last In, First Out)
LIFO assumes that the most recently purchased (or produced) goods are the first to be sold or used. This method values the closing stock based on older inventory, as the latest goods are assumed to be sold first.
Key Features of LIFO
- Last items purchased are sold first.
- The closing stock consists of the older inventory.
- Not permitted under IFRS (International Financial Reporting Standards) but is allowed in some jurisdictions, like the United States under GAAP.
Impact on Financial Statements
- During inflation: LIFO results in higher COGS and lower profits because newer, more expensive inventory is sold first, leaving the older, cheaper inventory as the closing stock.
- Closing Stock Value: The closing stock is valued at older purchase prices, which may not reflect current market values.
Example:
- Purchase 1: 100 units @ ₹50 = ₹5,000
- Purchase 2: 100 units @ ₹60 = ₹6,000
- Sale: 150 units
- Under LIFO, 100 units from the second purchase at ₹60 and 50 units from the first purchase at ₹50 are sold.
COGS = (100 * ₹60) + (50 * ₹50) = ₹6,000 + ₹2,500 = ₹8,500
Closing Stock = 50 units * ₹50 = ₹2,500
3. HIFO (Highest In, First Out)
HIFO assumes that the highest priced inventory is sold first, regardless of the order in which the items were purchased. This method is rarely used in practice but can be applicable in certain situations.
Key Features of HIFO
- Highest cost items are sold first.
- The closing stock is valued at the lower cost items, which may give a more conservative view of profitability.
Impact on Financial Statements
- During inflation: HIFO results in the highest COGS and lowest profits because the most expensive inventory is used up first, leaving cheaper items in stock.
- Closing Stock Value: The closing stock will be valued at the lowest purchase cost.
Example:
- Purchase 1: 100 units @ ₹50 = ₹5,000
- Purchase 2: 100 units @ ₹60 = ₹6,000
- Sale: 150 units
- Under HIFO, 100 units from the second purchase at ₹60 and 50 units from the first purchase at ₹50 are sold.
COGS = (100 * ₹60) + (50 * ₹50) = ₹6,000 + ₹2,500 = ₹8,500
Closing Stock = 50 units * ₹50 = ₹2,500
4. Weighted Average Method
The Weighted Average Method calculates the average cost of all inventory items available for sale during the period and applies this average to both the COGS and closing stock.
Key Features of the Weighted Average Method
- The cost of each unit sold or in stock is the average cost of all units available for sale.
- Suitable for businesses dealing with homogeneous products (e.g., commodities like oil, grains).
- The method smoothens out fluctuations in price over time.
Formula for Weighted Average Cost:
Impact on Financial Statements
- The COGS and closing stock will reflect the average cost of all inventory, rather than specific purchase prices.
- During inflation: The impact on profits is less dramatic compared to FIFO or LIFO, as the average cost smoothens price fluctuations.
Example:
Purchase 1: 100 units @ ₹50 = ₹5,000
Purchase 2: 100 units @ ₹60 = ₹6,000
Total Cost of Goods Available for Sale = ₹5,000 + ₹6,000 = ₹11,000
Total Units Available for Sale = 100 + 100 = 200 units
Weighted Average Cost per Unit = ₹11,000 / 200 = ₹55 per unit
Sale: 150 units
COGS = 150 units * ₹55 = ₹8,250
Closing Stock = 50 units * ₹55 = ₹2,750
Comparison of Methods
| Method | Cost of Goods Sold (COGS) | Closing Stock Value | Impact in Inflation | Usage |
|---|---|---|---|---|
| FIFO | Lower (Older, cheaper goods sold first) | Higher (Recent, expensive goods left in stock) | Lower profits, higher stock value | Suitable for perishable goods |
| LIFO | Higher (Newer, expensive goods sold first) | Lower (Older, cheaper goods left in stock) | Lower profits, lower stock value | Not allowed under IFRS |
| HIFO | Highest (Most expensive items sold first) | Lowest (Cheaper items left) | Lowest profits, lowest stock value | Rarely used |
| Weighted Average | Average cost applied to all sales | Average cost applied to closing stock | Smooths profit fluctuations | Suitable for homogeneous items |
Conclusion
The method of stock valuation chosen can significantly impact a business's financial statements, particularly profit margins and inventory valuation. FIFO and LIFO are the most common, with FIFO being widely used for its simplicity and relevance to many industries. HIFO is less commonly used but might be relevant in some specialized cases, while the Weighted Average Method provides a balanced approach to cost allocation, particularly for businesses with large volumes of homogeneous goods.
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