If your business buys and sells physical goods, one question sits quietly at the centre of your accounts: when you sell a unit of stock, which cost do you use to calculate your profit? This might sound like a technicality, but the answer can produce materially different profit figures, different balance sheet values, and different tax bills — all from the same physical reality of goods bought and sold. The choice of inventory valuation method determines how you assign the cost of goods to the units you sell (reducing profit) versus the units still sitting in your warehouse (remaining on the balance sheet). Three methods dominate in practice: FIFO, LIFO, and AVCO. Understanding how each works — and which applies to your business — is essential for any SME that holds stock.
Why Inventory Valuation Matters
Before exploring the three methods, it helps to be clear about what inventory valuation is actually doing. When you buy stock at different times, you often pay different prices. Supplier costs change, exchange rates fluctuate, and bulk discounts vary. At the end of any period, your warehouse might hold identical products that were purchased at £10, £12, and £14 per unit at different points in time.
When you sell one of those units, which cost flows through to your Cost of Goods Sold (COGS) on the profit and loss account — and which remains as closing stock on your balance sheet? The inventory valuation method you choose answers this question. And because COGS directly drives gross profit, and closing stock directly affects the balance sheet and therefore equity, the choice of method is not neutral. In a period of rising prices, different methods produce genuinely different financial results from the same underlying transactions.
You can read more about how COGS is calculated and why it matters in our guide to Cost of Goods Sold explained.
FIFO: First In, First Out
FIFO assumes that the oldest units of stock are sold first. The cost assigned to goods sold is the cost of the earliest purchases; the cost of the most recent purchases remains in closing stock.
In physical terms, FIFO mirrors how most perishable goods businesses actually operate — a bakery sells yesterday’s bread before today’s, and a grocer rotates stock so the oldest items face the front. But as an accounting assumption, FIFO applies even when there is no physical rotation — it is purely about which cost flows out first.
In a period of rising prices, FIFO produces a lower COGS (because cheaper older stock is expensed first) and a higher closing stock value (because more expensive recent purchases remain). The result is a higher gross profit. The balance sheet shows closing stock at the most current costs, making it a realistic reflection of what that stock would cost to replace.
FIFO is permitted under both UK GAAP (FRS 102) and IFRS. For most product-based SMEs in the UK and internationally, it is the default method.
LIFO: Last In, First Out
LIFO assumes the opposite: the most recently purchased stock is sold first. The cost of the newest units flows through to COGS; the oldest (and typically cheapest, in a rising market) costs remain in closing stock.
In a period of rising prices, LIFO produces a higher COGS and lower gross profit — because the most expensive recent purchases are expensed first. Closing stock is valued at older, cheaper prices, which means the balance sheet understates the current replacement cost of inventory.
The US has historically permitted LIFO under US GAAP, and some US businesses have used it specifically because higher COGS in inflationary periods reduces taxable income. However, LIFO is prohibited under IFRS and under UK GAAP (FRS 102). If your business reports under IFRS or UK GAAP — as most UK companies do — LIFO is not an available option. It is worth understanding for completeness, particularly if you work with US-based groups or encounter it in comparative analysis.
Key insight: Under IFRS and UK GAAP, the permitted inventory cost methods are FIFO and Weighted Average Cost (AVCO). LIFO is explicitly prohibited. Choosing between FIFO and AVCO is therefore the practical decision for most UK SMEs.
AVCO: Weighted Average Cost
AVCO (Weighted Average Cost, also called WAC or the average cost method) takes a different approach entirely. Rather than tracking which specific batch was sold first or last, it calculates a weighted average cost across all units in stock and applies that single average cost to every unit sold and every unit remaining.
The weighted average is recalculated each time new stock is purchased:
New Average Cost = (Value of Existing Stock + Cost of New Purchase) ÷ (Existing Units + New Units)
Each sale then uses the current average cost to calculate COGS, and the remaining stock is carried at that same average. When the next purchase arrives, the average is recalculated again.
AVCO smooths out price fluctuations. In a rising market, it produces a COGS and gross profit between what FIFO and LIFO would generate. It avoids the distortions of either extreme and is particularly suited to businesses with homogeneous, interchangeable stock where tracking individual batches is impractical.
Worked Example: Kestrel Components
Kestrel Components buys and sells an industrial fastener. During June, the following transactions occur:
| Date | Transaction | Units | Unit Cost | Total |
|---|---|---|---|---|
| 1 Jun | Opening stock | 100 | £10.00 | £1,000 |
| 8 Jun | Purchase | 150 | £12.00 | £1,800 |
| 15 Jun | Sale | 180 | — | — |
| 22 Jun | Purchase | 100 | £14.00 | £1,400 |
| 28 Jun | Sale | 100 | — | — |
At month-end, 70 units remain in stock (100 + 150 − 180 + 100 − 100 = 70). The question is: what is the COGS for the 280 units sold, and what is the value of the 70 units remaining?
Under FIFO
First sale (180 units): use 100 units at £10.00 (all opening stock), then 80 units at £12.00. COGS = (100 × £10) + (80 × £12) = £1,000 + £960 = £1,960.
Second sale (100 units): use the remaining 70 units at £12.00, then 30 units at £14.00. COGS = (70 × £12) + (30 × £14) = £840 + £420 = £1,260.
Total COGS: £3,220. Closing stock: 40 units at £14.00 = £560.
Under AVCO
After the 8 June purchase: average cost = (£1,000 + £1,800) ÷ (100 + 150) = £2,800 ÷ 250 = £11.20 per unit.
First sale (180 units): COGS = 180 × £11.20 = £2,016. Remaining: 70 units × £11.20 = £784.
After the 22 June purchase: new average = (£784 + £1,400) ÷ (70 + 100) = £2,184 ÷ 170 = £12.85 per unit.
Second sale (100 units): COGS = 100 × £12.85 = £1,285. Closing stock: 70 units × £12.85 = £899.50.
Total COGS: £3,301.
Side-by-Side Comparison
| Method | Total COGS | Closing Stock Value | Gross Profit Impact |
|---|---|---|---|
| FIFO | £3,220 | £560 | Higher (lower COGS) |
| AVCO | £3,301 | £899.50 | Lower (higher COGS) |
| LIFO (illustrative only — not permitted under IFRS/UK GAAP) | £3,580 | £200 | Lowest (highest COGS) |
Note that the total cost of goods available for sale is the same under all three methods: £1,000 + £1,800 + £1,400 = £4,200. The difference is only in how that total is split between COGS and closing stock. COGS + Closing Stock always equals the total available — the method simply determines the allocation.
Choosing the Right Method for Your Business
For UK and IFRS-reporting businesses, the practical choice is between FIFO and AVCO. Here is how to think about it.
FIFO is well suited to businesses where stock physically rotates — food, pharmaceuticals, perishables, time-sensitive goods. It produces a closing stock value closest to current replacement cost, making the balance sheet more meaningful to lenders and investors. In periods of rising prices, it reports higher profits — which can be an advantage for demonstrating financial performance but also means a higher tax liability.
AVCO is well suited to businesses with homogeneous, interchangeable stock where individual batch tracking is impractical — bulk commodities, raw materials, components. It smooths volatility in reported profit caused by price fluctuations, which can make period-to-period comparisons more stable. It is also simpler to operate in a perpetual inventory system that recalculates the average with each purchase.
The single most important rule is consistency: whichever method you choose must be applied consistently from period to period. Switching methods is permitted under accounting standards but requires disclosure and restatement of prior period comparatives — it is not a mechanism for managing reported profit in a given year. Any change must be justified as producing more reliable and relevant information, and the impact disclosed in the notes to the accounts.
For businesses operating across multiple entities — where one subsidiary might historically have used FIFO and another AVCO — consolidating group accounts requires harmonising inventory policies. This is one of many accounting policy alignment challenges that multi-entity finance teams encounter at the group reporting level.
Key Takeaways
- Inventory valuation determines which purchase cost flows to COGS (reducing profit) and which remains in closing stock (on the balance sheet). The same physical stock can produce different profit figures depending on the method used.
- FIFO (First In, First Out) assumes oldest stock is sold first. In rising prices, it produces lower COGS, higher gross profit, and closing stock valued at current prices.
- LIFO (Last In, First Out) assumes newest stock is sold first. It is prohibited under IFRS and UK GAAP and should not be used by businesses reporting under these standards.
- AVCO (Weighted Average Cost) calculates a running average cost and applies it to all sales. It smooths out price fluctuations and sits between FIFO and LIFO in profit impact.
- COGS + Closing Stock always equals the total cost of goods available for sale — the method only determines how that total is allocated between the two.
- Whichever method you choose must be applied consistently. Switching requires justification and disclosure — it cannot be used to manage reported profit.
- UK SMEs reporting under FRS 102 or IFRS should use FIFO or AVCO. Confirm with your accountant which best fits your business’s stock characteristics and reporting needs.
Related Reading
Inventory valuation sits at the intersection of cost accounting, profit reporting, and balance sheet management. These ARD guides provide the context around it:
- Cost of Goods Sold (COGS) Explained — how your chosen inventory valuation method flows directly into the COGS figure on your income statement.
- Understanding the Income Statement: A Complete Guide to Profit & Loss for SMEs — where COGS sits in the P&L and how it drives gross profit.
- Accounting Basics: The Balance Sheet: Structure and Key Elements — how closing stock is presented as a current asset and why its valuation affects equity.
- Financial Ratios Explained: Liquidity, Profitability, and Efficiency Ratios — how inventory valuation choices flow through to gross margin, current ratio, and stock turnover ratios.