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Inventory valuation is how you assign a dollar cost to the goods a business holds and to the goods it sells. The main methods are first-in first-out (FIFO), last-in first-out (LIFO), weighted average cost (WAC), and specific identification. Your choice changes cost of goods sold, gross profit, taxable income, and the inventory figure on the balance sheet, so it is a decision with real money attached.
This guide explains each method, works a numeric example, and shows how the same purchases can produce different profits depending on which method you apply. It is written for controllers and finance owners who need the mechanics, not a textbook definition.
What is inventory valuation?
Inventory valuation is the accounting process of putting a cost on unsold goods (reported as an asset) and on sold goods (reported as cost of goods sold). Because purchase prices change over time, a company holding identical items bought at different prices needs a rule to decide which cost flows to the income statement when a unit sells. That rule is the inventory valuation method, and under US GAAP you apply it consistently from period to period.
The four inventory valuation methods
| Method | Which cost flows to COGS first | Effect in rising prices |
|---|---|---|
| FIFO | Oldest (first purchased) | Lower COGS, higher profit, higher tax |
| LIFO | Newest (last purchased) | Higher COGS, lower profit, lower tax |
| Weighted average (WAC) | Blended average cost per unit | Result sits between FIFO and LIFO |
| Specific identification | The exact cost of the item sold | Used for unique, high-value goods |
Worked example
Say a company buys 100 units at $10, then 100 more at $14, and sells 120 units. Under FIFO, COGS is the 100 units at $10 plus 20 units at $14, which is $1,280, leaving 80 units at $14 ($1,120) in ending inventory. Under LIFO, COGS is the 100 units at $14 plus 20 at $10, which is $1,600, leaving $1,000 in inventory. Under weighted average, the blended cost is $12 per unit, so COGS is 120 times $12, which is $1,440. Same purchases, three different profit figures.
FIFO vs LIFO
FIFO assumes the oldest stock sells first, which matches how most businesses physically move goods, especially perishables. In a period of rising costs, FIFO leaves the newer, higher costs in inventory and pushes the older, lower costs to COGS, so reported profit and taxes are higher. LIFO does the reverse: it sends the newest, highest costs to COGS, which lowers taxable income when prices rise. LIFO is permitted under US GAAP but banned under IFRS, so US companies that report internationally often avoid it.
Weighted average cost
Weighted average cost smooths out price swings by dividing total inventory cost by total units to get one average cost per unit, then applying that average to both units sold and units remaining. It is simple to run in a periodic system and is common for commodity-like goods where individual units are indistinguishable. The result always lands between the FIFO and LIFO figures.
How inventory valuation feeds cost of goods sold
Inventory valuation and cost of goods sold are two sides of the same entry. Every dollar you assign to a unit that sells becomes COGS; every dollar assigned to a unit still on the shelf stays in inventory. Because COGS drives gross profit, the valuation method you pick directly sets your margin. Controllers watching gross margin trends need to know that a shift in method, or a shift in purchase prices under the same method, can move margin without any change in what the business actually sold.
Lower of cost or net realizable value
GAAP does not let inventory sit on the books at a cost higher than what it can be sold for. Under the lower of cost or net realizable value rule, when the market value of inventory drops below its recorded cost, you write it down to net realizable value and take the loss now. This keeps the balance sheet honest and prevents obsolete or damaged stock from being carried at an inflated figure.
Which inventory valuation method should you use?
Use FIFO if you want financials that reflect current replacement costs in inventory and you are comfortable with higher reported profit and tax when prices rise; it is the most widely used method and works for most businesses. Use LIFO mainly for the tax deferral it offers in inflationary periods, and only if you are prepared for the extra recordkeeping and the IFRS incompatibility. Use weighted average for high-volume, interchangeable goods where tracking individual lots is impractical. Use specific identification only for unique, serialized, high-value items like vehicles or custom equipment. Once you choose, apply it consistently, because switching methods requires disclosure and can trigger a tax filing.
Keeping inventory costs accurate
Whatever method you run, the numbers are only as good as the purchase costs feeding them, and those costs arrive on vendor invoices. Freight, duties, and supplier price changes all belong in the unit cost, and missing them understates inventory and COGS. Pulling clean line-item data off every bill through accounts payable automation software keeps landed costs accurate, and exporting the ledger to a spreadsheet you can slice by item makes period-end inventory reconciliation far quicker. Tie inventory back to your days payable outstanding and you get a full picture of how working capital is tied up in stock and supplier terms.
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