What you'll learn
This topic examines how businesses value their inventory using two key methods: FIFO (First In First Out) and AVCO (Average Cost). You need to calculate closing inventory values, cost of sales, and understand how each method affects gross profit calculations. CIE IGCSE Accounting examiners frequently test this through calculation questions worth 6-12 marks, often requiring you to complete inventory cards and explain the impact on financial statements.
Key terms and definitions
Inventory — goods held by a business for resale or raw materials used in production; also called stock.
FIFO (First In First Out) — an inventory valuation method that assumes the first items purchased are the first items sold, so closing inventory consists of the most recently purchased goods.
AVCO (Average Cost) — an inventory valuation method that calculates a weighted average cost per unit after each purchase, using this average to value both issues and closing inventory.
Inventory card — a detailed record showing dates, receipts (purchases), issues (sales), and the balance of inventory with quantities and values.
Cost of sales — the cost of inventory that has been sold during a period, calculated as opening inventory + purchases – closing inventory.
Closing inventory — the value of goods remaining unsold at the end of an accounting period.
Weighted average — the average cost per unit calculated by dividing the total value of inventory by the total quantity available.
Perpetual inventory system — a continuous record-keeping system that updates inventory balances after each transaction.
Core concepts
Understanding inventory valuation methods
Businesses need to value inventory consistently and accurately because it directly impacts:
- Gross profit — higher closing inventory increases gross profit
- Statement of financial position — inventory appears as a current asset
- Cost of sales — lower closing inventory increases cost of sales
CIE IGCSE Accounting requires you to apply two methods: FIFO and AVCO. The choice of method affects reported profits, particularly during periods of changing prices.
FIFO method explained
The FIFO method assumes inventory flows in chronological order — the oldest items sell first. This reflects the physical flow in many businesses (especially those selling perishable goods).
Key FIFO principles:
- Issues are taken from the oldest inventory batch first
- Closing inventory consists of the most recent purchases
- Each batch retains its original purchase price
- During inflation, FIFO produces higher closing inventory values and higher gross profit
- During deflation, FIFO produces lower closing inventory values and lower gross profit
How to complete a FIFO inventory card:
- Record all purchases in the Receipts column with date, quantity, unit cost, and total value
- For each issue (sale), take units from the oldest batch first
- If one batch doesn't cover the full issue, take remaining units from the next oldest batch
- Calculate the Balance after each transaction, showing separately each batch still in inventory
- The final Balance row shows your closing inventory value
AVCO method explained
The AVCO method calculates a new weighted average cost per unit after every purchase. This average cost then values all subsequent issues until the next purchase.
Key AVCO principles:
- A new average cost is calculated after each purchase (not after sales)
- All inventory units are treated identically regardless of purchase date
- The formula is: New average cost = Total value of inventory ÷ Total quantity
- AVCO produces inventory values between FIFO and LIFO (Last In First Out, not required for CIE IGCSE)
- AVCO smooths out price fluctuations over time
How to complete an AVCO inventory card:
- Record purchases in the Receipts column
- After each purchase, calculate the new weighted average:
- Add the new purchase value to the existing balance value
- Divide by total units now available
- Use this average cost to value all issues until the next purchase
- The Balance column shows quantity × current average cost
- Round average costs sensibly (usually to 2-3 decimal places)
Comparing FIFO and AVCO
When prices are rising (inflation):
- FIFO gives higher closing inventory values
- FIFO gives higher gross profit
- AVCO gives lower closing inventory values
- AVCO gives lower gross profit
When prices are falling (deflation):
- FIFO gives lower closing inventory values
- FIFO gives lower gross profit
- AVCO gives higher closing inventory values
- AVCO gives higher gross profit
When prices are stable:
- Both methods produce identical results
Impact on financial statements
The inventory valuation method chosen affects:
Trading account / Income statement:
- Different cost of sales figures
- Different gross profit amounts
- Net profit is also affected
Statement of financial position:
- Different current asset values
- Different working capital figures
- Different capital (retained profit) amounts
The difference between methods narrows over the long term but can be significant in any single accounting period.
Recording inventory in financial statements
Regardless of method used, the accounting treatment follows:
Cost of sales calculation:
Opening inventory
+ Purchases
= Cost of goods available for sale
– Closing inventory
= Cost of sales
Double entry for closing inventory:
- Debit Closing inventory (statement of financial position - current asset)
- Credit Trading account (reduces cost of sales)
The inventory valuation method determines the closing inventory figure used in these entries.
Worked examples
Example 1: FIFO inventory card
A business trades in Product X. Complete the inventory card using the FIFO method:
Transactions:
- March 1: Balance 100 units @ $10 each
- March 8: Purchased 150 units @ $12 each
- March 15: Issued 180 units
- March 22: Purchased 200 units @ $13 each
- March 28: Issued 140 units
Solution:
| Date | Receipts | Issues | Balance |
|---|---|---|---|
| Qty | Unit Cost | Value | |
| Mar 1 | |||
| Mar 8 | 150 | $12 | $1,800 |
| Mar 15 | |||
| Mar 22 | 200 | $13 | $2,600 |
| Mar 28 | |||
Closing inventory value: $1,690 (130 units @ $13)
Explanation: On March 15, the issue of 180 units takes all 100 units @ $10, then 80 of the units @ $12, leaving 70 units @ $12. On March 28, the issue of 140 units takes the remaining 70 @ $12 and 70 @ $13, leaving 130 @ $13.
Example 2: AVCO inventory card
Using the same transactions, complete the inventory card using the AVCO method:
Solution:
| Date | Receipts | Issues | Balance |
|---|---|---|---|
| Qty | Unit Cost | Value | |
| Mar 1 | |||
| Mar 8 | 150 | $12 | $1,800 |
| Mar 15 | |||
| Mar 22 | 200 | $13 | $2,600 |
| Mar 28 |
Closing inventory value: $1,630 (rounded)
Explanation: After the March 8 purchase, average cost = $2,800 ÷ 250 = $11.20. This values the March 15 issue. After the March 22 purchase, new average = ($784 + $2,600) ÷ 270 = $12.526, rounded to $12.53. This values the March 28 issue.
Example 3: Impact on gross profit
Using the data from Examples 1 and 2, calculate gross profit for March if sales revenue was $6,500:
FIFO method:
Sales revenue: $6,500
Opening inventory: $1,000
Purchases: $4,400
$5,400
Less closing inventory: $1,690
Cost of sales: $3,710
Gross profit: $2,790
AVCO method:
Sales revenue: $6,500
Opening inventory: $1,000
Purchases: $4,400
$5,400
Less closing inventory: $1,630
Cost of sales: $3,770
Gross profit: $2,730
Analysis: FIFO produces $60 higher gross profit because closing inventory is $60 higher, making cost of sales $60 lower. This demonstrates how rising prices cause FIFO to report higher profits.
Common mistakes and how to avoid them
Mistake 1: Mixing batches incorrectly in FIFO Students often take units randomly rather than from the oldest batch first. Always issue from the earliest purchase date, completely clearing each batch before moving to the next. Show each batch separately in the Balance column.
Mistake 2: Calculating AVCO after every transaction AVCO is recalculated only after purchases, not after issues. After an issue, the average cost remains unchanged — only the quantity and total value decrease. Wait until the next receipt to recalculate.
Mistake 3: Rounding errors in AVCO Rounding the average cost too early creates compounding errors. Carry at least three decimal places in your working (e.g., $12.526) and round only the final answer. Check that quantity × average cost equals the balance value.
Mistake 4: Forgetting to update the balance After every transaction (receipt or issue), you must calculate the new balance. The Balance column is not optional — it's essential for tracking inventory and forms the basis for the next transaction.
Mistake 5: Confusing FIFO with physical movement FIFO is an accounting assumption, not necessarily reflecting actual physical stock movement. A warehouse might sell from any location, but the accounting records value issues as if the oldest stock sold first.
Mistake 6: Incorrectly calculating cost of sales Remember the formula: Opening inventory + Purchases – Closing inventory. A common error is adding closing inventory instead of subtracting it, which completely reverses the relationship between inventory values and cost of sales.
Exam technique for Inventory Valuation: FIFO and AVCO
Command words and mark allocation:
- "Complete the inventory card" (8-10 marks) — requires all columns filled accurately with dates, quantities, unit costs, and values
- "Calculate the value of closing inventory" (2-4 marks) — show method used and clear working
- "State which method produces the higher gross profit" (1-2 marks) — name the method and the amount, with brief reasoning if required
- "Explain the effect on profit" (3-4 marks) — compare both methods, link higher closing inventory to higher gross profit with figures
Structure your answers effectively:
- Use a ruler to draw neat inventory card tables; examiners penalize unclear layouts
- Label all columns (Receipts, Issues, Balance with Qty/Unit Cost/Value subheadings)
- Show all working for AVCO calculations, even if not explicitly requested — method marks are available
- Always state your final answer clearly, e.g., "Closing inventory using FIFO: $1,690"
Time management:
A full inventory card question typically carries 8-10 marks and should take 12-15 minutes. Practice completing cards without a calculator first to develop number sense, then use calculators efficiently in the exam. Double-check that your balance column updates after every transaction.
Showing method marks:
Even if your final answer is incorrect, you can earn method marks by showing correct technique. For AVCO, write the formula: "Total value ÷ Total quantity = Average cost per unit." For FIFO, clearly show which batch each issue comes from.
Quick revision summary
FIFO assumes oldest inventory sells first; closing inventory consists of most recent purchases. AVCO calculates weighted average cost after each purchase. During inflation, FIFO produces higher closing inventory and higher gross profit than AVCO. Complete inventory cards by recording receipts, calculating issues using the stated method, and updating the balance after each transaction. For FIFO, issue from oldest batches first; for AVCO, recalculate average cost only after purchases. Higher closing inventory reduces cost of sales and increases gross profit. Both methods are acceptable under CIE IGCSE Accounting standards; businesses choose based on their needs.