Inventory valuation methods: FIFO vs weighted average for Indian small businesses

Closing stock is valued at cost or net realisable value, whichever is lower, using either FIFO (first in, first out) or weighted average cost. LIFO is not permitted in India under AS 2 or ICDS II. The method you pick changes your reported profit in years when prices move, so pick one, apply it consistently, count stock physically at least at year end, and write down dead stock to what it will actually fetch.

Why the closing stock number matters so much

For a trader or manufacturer, cost of goods sold is worked out as opening stock plus purchases minus closing stock. Closing stock is the only one of the three you estimate rather than record from bills. That makes it the single number with the most influence on your profit, your tax and your bank's opinion of you.

Say a Jaipur handicrafts exporter has opening stock ₹8,00,000, purchases ₹52,00,000 and sales ₹75,00,000. If closing stock is ₹10,00,000, cost of goods sold is ₹50,00,000 and gross profit is ₹25,00,000. If closing stock is valued at ₹12,00,000 instead, gross profit becomes ₹27,00,000. Same year, same sales, ₹2 lakh more taxable profit from a valuation choice. That is why the method and the count both have to be defensible.

What "cost" includes

Under AS 2 and ICDS II (Valuation of Inventories), cost has three parts:

• Cost of purchase: the invoice price plus freight inward, loading and unloading, and non-refundable duties and taxes, less trade discounts and rebates. GST that you claim as input credit is not part of cost.
• Cost of conversion (manufacturers only): direct labour and a systematic share of factory overheads such as power, factory rent and depreciation of machines. Abnormal waste and idle capacity costs are excluded.
• Other costs incurred to bring the stock to its present location and condition, such as job-work charges.

What cost does not include: storage after purchase (unless necessary for the next production stage), administrative overheads, selling and distribution costs, and interest (except in specific cases under ICDS IX). A trader's cost, in practice, is purchase price plus inward freight and loading.

FIFO explained

FIFO assumes the goods you bought first are the ones you sell first, so closing stock consists of the most recent purchases. It matches the physical flow in most trades (you do sell old stock first) and it gives a closing stock value close to current prices.

In a rising-price market, FIFO gives lower cost of goods sold (you are charging older, cheaper purchases to sales), higher profit and higher tax. In a falling market it does the opposite.

Weighted average explained

Weighted average recalculates the average cost per unit after every purchase (or at the end of a period, called periodic weighted average). Closing stock is units on hand times the latest average cost. It smooths out price fluctuations and is easier to compute when you have many lots of the same item at slightly different prices, which is why most billing and inventory software defaults to it.

Worked example: a Kochi electronics shop

Nisha's shop in Kochi deals in a particular power bank model. During March 2027 she has these movements:

Units available: 40 + 60 + 50 = 150. Units sold: 70 + 45 = 115. Closing stock: 35 units.

FIFO. The 35 units left are the last ones bought, all from the 22 March lot at ₹1,200. Closing stock = 35 × 1,200 = ₹42,000. Cost of goods sold = total cost of purchases available (44,000 + 69,000 + 60,000 = ₹1,73,000) minus 42,000 = ₹1,31,000.

Weighted average (periodic). Average cost = 1,73,000 ÷ 150 = ₹1,153.33 per unit. Closing stock = 35 × 1,153.33 = ₹40,367. Cost of goods sold = 1,73,000 − 40,367 = ₹1,32,633.

Weighted average (perpetual, recomputed after each purchase). After 8 March: 100 units costing 1,13,000, average ₹1,130. Sale of 70 at ₹1,130 = 79,100; 30 units left worth 33,900. After 22 March: 80 units costing 33,900 + 60,000 = 93,900, average ₹1,173.75. Sale of 45 at ₹1,173.75 = 52,819; 35 units left worth 35 × 1,173.75 = ₹41,081. Cost of goods sold = 79,100 + 52,819 = ₹1,31,919.

If Nisha sold the 115 units at ₹1,500 each, revenue is ₹1,72,500. Gross profit is ₹41,500 under FIFO, ₹39,867 under periodic average and ₹40,581 under perpetual average. Small on one product; across a shop with 400 SKUs in a year of rising prices it can be a lakh or more of profit and 30% of that in tax.

Cost or net realisable value, whichever is lower

Cost is only the ceiling. If an item will sell for less than what you paid (obsolete phone models, last season's fabric prints, near-expiry FMCG), value it at net realisable value: estimated selling price less the costs needed to make the sale. The comparison is done item by item or by groups of similar items, not for the whole stock in one shot. So you cannot offset a loss on power banks against a gain on chargers.

Example: 20 units of an older power bank model cost ₹1,100 each but will now fetch only ₹800 after a ₹50 platform fee. NRV = ₹750. Value them at 20 × 750 = ₹15,000, not ₹22,000. The ₹7,000 write-down is a genuine deduction this year, and it stops you from carrying a fictional asset into next year.

Why LIFO is not allowed and what else is

LIFO (last in, first out) assumes the newest stock is sold first, which rarely matches reality and lets a business hold very old, very low-cost stock on the balance sheet forever. AS 2 removed it in 2000 and ICDS II, which governs income-tax computation from FY 2016-17, does not permit it either. If your old spreadsheet uses LIFO, switch and disclose the change.

Specific identification (tracking the exact cost of each unit) is required where items are not interchangeable, for example a jeweller's individual pieces or a used-car dealer's vehicles. Standard cost (a pre-set cost per unit, adjusted for variances) and the retail method (selling price less a margin percentage) are acceptable techniques if the result approximates actual cost, which is how many retail chains manage thousands of SKUs.

Effect on profit, tax and the following year

Whatever you choose, the total profit over the life of the stock is the same; only the timing changes. This year's closing stock is next year's opening stock, so a high valuation that raises this year's profit lowers next year's. The Income Tax Act cares about two things: consistency (Section 145 and ICDS II require the same method year after year unless there is a good reason) and the lower-of-cost-or-NRV rule.

Section 145A adds a wrinkle. For tax computation, purchases, sales and stock are to be shown inclusive of GST (the "inclusive method"). Since the GST on opening and closing stock nets out with the GST on purchases and sales, the profit is the same as under the exclusive method used in your books. Your CA makes the grossing-up adjustment in the return and the tax audit report (Clause 14 of Form 3CD asks for the valuation method and any deviation from ICDS). Under presumptive tax (Section 44AD), stock valuation does not affect the 8% or 6% deemed profit, but the balance sheet you disclose should still be sensible.

Stock statements for cash credit and overdraft limits

If you have a cash credit (CC) or overdraft limit against stock and book debts, the bank asks for a monthly stock statement, typically by the 10th of the following month. It uses this to compute drawing power:

Drawing power = (Stock value − margin) + (Debtors up to 90 days − margin) − Creditors

Margins are commonly 25% on stock and 40% on debtors, and debtors older than 90 days are excluded entirely; your sanction letter states the exact terms. If drawing power falls below the amount you have drawn, the account is irregular and the bank will call for immediate reduction.

Example: a Surat fabric trader has a ₹20 lakh CC limit. Stock ₹18,00,000, debtors under 90 days ₹9,00,000, creditors ₹6,00,000. Drawing power = (18,00,000 × 75%) + (9,00,000 × 60%) − 6,00,000 = 13,50,000 + 5,40,000 − 6,00,000 = ₹12,90,000. He can draw only ₹12.9 lakh of his ₹20 lakh limit this month. Reducing creditors or collecting old udhaar directly raises the usable limit.

Banks compare the stock in the statement with the stock in your GST returns and financial statements. A stock statement that shows ₹18 lakh every month while GSTR-3B purchases and sales imply ₹9 lakh is a red flag that brings a stock audit. Use the same valuation method for the bank and the books.

Physical count discipline

Valuation is only as good as the count. Book stock drifts from real stock because of unbilled sales, breakages, theft, wrong item selected at billing, and free replacements not recorded.

• Count everything on 31 March, or within a day or two with a cut-off note listing goods received and dispatched around the date.
• Freeze movements during the count, or count godown by godown with sealed sections.
• Use a printed count sheet with item code, location, counted quantity, and a column for the counter's initials; never count from the system quantity.
• Do cycle counts through the year: fast-moving items monthly, the rest quarterly. Small businesses that count only in March discover a ₹3 lakh gap with no idea when it happened.
• Investigate differences above a tolerance (say 2% of item value) before adjusting the books, and book the adjustment as a stock loss, not by quietly changing purchases.
• Goods lost, stolen or destroyed require reversal of GST input credit under Section 17(5)(h); write-offs of damaged goods are the same. Keep a note.

Dead stock: recognise it, price it, move it

Dead stock is inventory that has not moved in six to twelve months. It ties up cash, occupies space, and is usually worth less than the book value. Run an ageing report on stock the same way you age debtors: items by last sale date. Then value dead items at NRV, decide whether to clear them at a discount, bundle them, return them to the supplier, or scrap them. A written-down item that later sells at a better price simply gives you profit in that year.

Reorder discipline prevents dead stock from forming. Set a minimum level and a reorder quantity for each item based on daily sales and supplier lead time, and stop buying items that show no sales in the last quarter.

Common mistakes

Changing methods to suit the year's profit. Using FIFO when prices fall and average when they rise is exactly what ICDS II forbids. Pick one.

Valuing stock at MRP or selling price. Overstates assets and profit; assessing officers know this trick.

Including GST in stock when you claim credit. Double-counts the tax as both credit and asset.

Never writing down dead stock. Old designs valued at cost for five years inflate the balance sheet and mislead the bank.

Counting from the software. A count that starts with the system quantity and ticks it is not a count.

Inconsistent bank statements. Stock statement, GST returns and the balance sheet must tell one story; the bank cross-checks.

Forgetting goods in transit and goods with job workers. Stock you have paid for but not received on 31 March, and material lying with a job worker (sent under a delivery challan), is still your stock.

How VyaparKit helps

VyaparKit will not run your stock ledger, but it gives you the sheets and calculators around the count. Print a stock count sheet by location for the March count, then use the stock valuation tool to value the counted quantities at FIFO or weighted average from your purchase rates. The low stock calculator and reorder calculator set minimum levels so slow items stop being reordered, and recording supplier invoices as a purchase bill keeps the purchase rates you need for valuation in one place.

Next steps

• Decide FIFO or weighted average for your business and write it down; tell your CA.
• Schedule the 31 March physical count now and print count sheets a week before.
• Age your stock by last sale date and list every item unsold for over six months.
• Recompute drawing power from your last stock statement and see how much of your CC limit is actually usable.
• Read balance sheet explained simply to see where the valued stock lands and how the bank reads it.