What you'll learn
Inventory valuation is a fundamental topic in IGCSE Accounting that determines how businesses measure the cost of goods sold and closing stock. This guide covers the two permitted methods—FIFO and AVCO—their impact on profit calculation, and the application of IAS 2 valuation principles. You'll learn to apply these methods accurately in examinations and understand their effects on financial statements.
Key terms and definitions
Inventory — goods held by a business for resale or use in production, also known as stock.
FIFO (First In, First Out) — a stock valuation method that assumes the earliest goods purchased are the first to be sold.
AVCO (Average Cost) — a stock valuation method that calculates a weighted average cost per unit after each purchase or at the period end.
Cost of goods sold (COGS) — the direct cost of inventory that has been sold during an accounting period.
Closing inventory — the value of unsold stock remaining at the end of an accounting period.
Net realisable value (NRV) — the estimated selling price less any costs required to complete and sell the goods.
IAS 2 — the International Accounting Standard that governs inventory valuation, requiring stock to be valued at the lower of cost and net realisable value.
Opening inventory — the value of stock brought forward from the previous accounting period.
Core concepts
Why inventory valuation matters
The value placed on closing inventory directly affects both the statement of profit or loss and the statement of financial position. Higher closing inventory values result in:
- Lower cost of goods sold
- Higher gross profit
- Higher net profit
- Higher current assets on the statement of financial position
The formula connecting these elements is:
Cost of goods sold = Opening inventory + Purchases – Closing inventory
This relationship means inventory valuation is critical for accurate profit measurement. Different valuation methods can produce different profit figures from identical transactions.
FIFO method
FIFO assumes that goods purchased first are sold first. This method matches the physical flow of goods in many businesses, particularly those selling perishable items.
How FIFO works:
- Identify opening inventory and its cost
- Record purchases in chronological order
- When sales occur, assume the oldest inventory is sold first
- Closing inventory consists of the most recent purchases
Advantages of FIFO:
- Reflects actual physical flow in many businesses
- Closing inventory valued at recent (more current) prices
- Easier to understand and apply
- Acceptable under IAS 2
In periods of rising prices:
- Closing inventory shows higher values (recent, higher-priced purchases)
- Cost of goods sold reflects older, lower costs
- Results in higher gross profit compared to AVCO
AVCO method
AVCO calculates a weighted average cost per unit. There are two approaches: calculating a new average after each purchase (continuous) or calculating one average for the entire period (periodic). IGCSE typically uses the continuous method.
How AVCO works (continuous):
- Start with opening inventory value and quantity
- After each purchase, calculate: Total value ÷ Total quantity = New average cost per unit
- Value issues (sales) at the current average cost
- Recalculate average after the next purchase
- Closing inventory valued at the final average cost
Advantages of AVCO:
- Smooths out price fluctuations
- Reduces impact of unusual purchases
- Acceptable under IAS 2
- Fair representation when goods are mixed together
In periods of rising prices:
- Produces profit figures between FIFO extremes
- Closing inventory valued between oldest and newest costs
- More stable profit patterns over time
Applying the lower of cost and NRV rule
IAS 2 requires inventory to be valued at the lower of cost and net realisable value. This follows the accounting concept of prudence (conservatism).
Cost includes:
- Purchase price
- Import duties and non-recoverable taxes
- Transport and handling costs
- Other costs directly attributable to acquisition
Net realisable value is:
- Expected selling price
- Less: costs to complete the goods
- Less: costs necessary to make the sale
Application:
Compare cost with NRV for each inventory line (or groups of similar items). Use the lower figure. This prevents inventory being overstated and ensures losses are recognised immediately.
Example scenario:
Product A: Cost £500, NRV £600 → Value at £500 Product B: Cost £800, NRV £700 → Value at £700 (write-down of £100)
The £100 write-down is recorded as an expense, reducing profit in the current period.
Impact on financial statements
Statement of profit or loss:
- Closing inventory affects cost of goods sold
- Higher closing inventory = higher gross profit
- Lower closing inventory = lower gross profit
- Write-downs to NRV appear as expenses
Statement of financial position:
- Closing inventory appears as a current asset
- Valued using FIFO, AVCO, or lower of cost and NRV
- Must be clearly disclosed in notes if material
Consistency concept:
Businesses must use the same valuation method consistently from year to year. Changing methods requires disclosure and justification.
Inventory records and stock cards
Stock cards (also called inventory cards) track individual inventory items. They typically show:
- Date of transaction
- Details (purchase/sale)
- Receipts (purchases): quantity, unit cost, total cost
- Issues (sales): quantity, unit cost, total cost
- Balance: quantity, unit cost, total value
Stock cards facilitate both FIFO and AVCO calculations by maintaining a running record of inventory movements.
Worked examples
Example 1: FIFO calculation
JM Trading had the following transactions in March:
- March 1: Opening inventory 100 units @ £5 each = £500
- March 10: Purchased 200 units @ £6 each = £1,200
- March 15: Sold 180 units
- March 25: Purchased 150 units @ £7 each = £1,050
- March 30: Sold 120 units
Required: Calculate closing inventory and cost of goods sold using FIFO.
Solution:
Sales on March 15 (180 units):
- 100 units @ £5 = £500
- 80 units @ £6 = £480
- Total cost: £980
Remaining inventory after March 15:
- 120 units @ £6 = £720
After purchase on March 25:
- 120 units @ £6 = £720
- 150 units @ £7 = £1,050
- Total: 270 units, £1,770
Sales on March 30 (120 units):
- 120 units @ £6 = £720
Closing inventory:
- 150 units @ £7 = £1,050
Cost of goods sold:
- March 15: £980
- March 30: £720
- Total: £1,700
Verification: Opening inventory (£500) + Purchases (£1,200 + £1,050) – COGS (£1,700) = Closing inventory (£1,050) ✓
Example 2: AVCO calculation
Using the same data as Example 1, calculate closing inventory and cost of goods sold using AVCO.
Solution:
March 1: Opening inventory 100 units @ £5 = £500
March 10: Purchase 200 units @ £6 = £1,200
- Total: 300 units, £1,700
- Average cost: £1,700 ÷ 300 = £5.67 per unit (to 2 decimal places)
March 15: Sold 180 units @ £5.67 = £1,020.60
- Remaining: 120 units @ £5.67 = £680.40
March 25: Purchase 150 units @ £7 = £1,050
- Total: 270 units, £1,730.40
- Average cost: £1,730.40 ÷ 270 = £6.41 per unit (to 2 decimal places)
March 30: Sold 120 units @ £6.41 = £769.20
- Remaining: 150 units @ £6.41 = £961.50
Closing inventory: £961.50 (or 150 units @ £6.41)
Cost of goods sold:
- March 15: £1,020.60
- March 30: £769.20
- Total: £1,789.80
Verification: £500 + £2,250 – £1,789.80 = £960.20 (minor rounding difference acceptable)
Example 3: Lower of cost and NRV
Apex Ltd holds three product lines on 31 December:
| Product | Quantity | Cost per unit | NRV per unit |
|---|---|---|---|
| X | 50 | £20 | £25 |
| Y | 80 | £15 | £12 |
| Z | 100 | £10 | £10 |
Required: Calculate the value of closing inventory applying IAS 2.
Solution:
Product X: 50 units × £20 (lower of £20 and £25) = £1,000 Product Y: 80 units × £12 (lower of £15 and £12) = £960 Product Z: 100 units × £10 (lower of £10 and £10) = £1,000
Total closing inventory: £2,960
Write-down calculation: Product Y: (£15 – £12) × 80 units = £240 loss
This £240 would be recorded as an expense in the statement of profit or loss, reducing net profit.
Common mistakes and how to avoid them
Mixing FIFO and AVCO in the same question — Read the question carefully to identify which method is required. Never use both unless specifically instructed to compare them.
Incorrect AVCO calculations — Recalculate the average after EVERY purchase, not just at the end. Use the formula: (Total value of inventory) ÷ (Total quantity) after each purchase transaction.
Forgetting to apply lower of cost and NRV — Always check whether the question mentions damaged, obsolete, or slow-moving inventory. These trigger the NRV rule.
Rounding errors — When using AVCO, round to two decimal places for currency but maintain precision throughout calculations. Only round the final answer for presentation.
Incorrect stock card layouts — In FIFO, separate layers of inventory at different costs. In AVCO, show the recalculated average after purchases clearly. Label columns correctly: Receipts, Issues, Balance.
Forgetting to verify answers — Use the formula: Opening inventory + Purchases – COGS = Closing inventory. Your closing inventory and COGS figures must satisfy this equation.
Exam technique for "Inventory Valuation"
Command word "Calculate" — Show full workings in a logical sequence. Examiners award method marks even if your final answer is incorrect. For AVCO, show each average calculation clearly. For FIFO, demonstrate which layers you're using.
Present stock cards properly — Use columnar format with clear headings (Date, Details, Receipts, Issues, Balance). Subdivide Receipts, Issues, and Balance into Quantity, Unit Cost, and Total Value. This format typically earns presentation marks.
Marks allocation guides your detail — A 6-mark question requires approximately 6 distinct calculation steps or decisions. Don't skip stages. Show opening inventory, each purchase effect, each sale calculation, and closing balance separately.
Comparison questions — When asked to compare FIFO and AVCO, calculate both methods fully then state clearly which produces higher profit and why. In rising prices: FIFO gives higher profit; in falling prices: AVCO gives higher profit. Link your answer to the context provided.
Quick revision summary
Inventory valuation uses FIFO (oldest stock sold first) or AVCO (weighted average recalculated after purchases). FIFO values closing inventory at recent prices; AVCO smooths price fluctuations. Both are IAS 2 compliant. Apply the lower of cost and net realisable value to prevent overstatement. Higher closing inventory increases profit through the cost of goods sold formula. Show detailed workings in stock card format, recalculate AVCO after each purchase, and verify calculations using the inventory equation. Different methods produce different profits in periods of changing prices.