Inventory valuation for manufacturers: weighted average vs FIFO
Your closing stock figure moves your profit rupee for rupee. Here's what Indian standards allow, how FIFO and weighted average differ on real numbers, and why a moving average kept with every transaction beats a figure typed in at year end.
In short
- AS 2, Ind AS 2 and ICDS II all measure inventory at the lower of cost and net realisable value, using FIFO or weighted average cost. LIFO is not allowed.
- Cost includes purchase price (net of GST you can claim as credit), freight inward and the cost of converting materials into finished goods. Abnormal wastage, storage, administration and selling costs are excluded.
- With rising prices, FIFO gives a higher closing stock and profit; weighted average smooths prices out. Over a full cycle, both add up to the same total cost.
- A moving weighted average, updated with every receipt, lets every issue, production order and invoice carry a cost on the day it happens.
- Once you choose a method, apply it consistently. Changing it is a change in accounting policy that must be disclosed.
Indian manufacturers must value inventory at the lower of cost and net realisable value, using either FIFO or weighted average cost. That is the rule in AS 2 (for most SMEs), Ind AS 2 (for larger and listed companies) and ICDS II (for computing taxable income). LIFO is not permitted under any of them. Within those rules, the method you choose and how carefully you apply it decide your gross margin, your balance sheet and the tax you pay.
Many SMEs still arrive at closing stock by counting at year end and pricing the count at the latest purchase rate in a spreadsheet. It works, roughly, once a year. It tells you nothing about the cost of the order you shipped last Tuesday.
What do AS 2, Ind AS 2 and ICDS II allow?
| AS 2 | Ind AS 2 | ICDS II | |
|---|---|---|---|
| Who uses it | Most unlisted companies and other entities | Listed and larger companies | Everyone, for computing taxable income |
| Measurement | Lower of cost and NRV | Lower of cost and NRV | Lower of cost and NRV |
| Cost formulas | FIFO or weighted average | FIFO or weighted average | FIFO or weighted average |
| LIFO | Not allowed | Not allowed | Not allowed |
| Specific identification | For items not ordinarily interchangeable | For items not ordinarily interchangeable | For items not ordinarily interchangeable |
Specific identification is for things like a custom-built machine or a made-to-order job, where each unit is distinct. For interchangeable raw materials and standard finished goods, it's FIFO or weighted average.
What goes into the cost of inventory?
- Cost of purchase: the purchase price, import duties and non-recoverable taxes, freight inward and handling, less trade discounts. GST you can claim as input tax credit is not part of cost.
- Cost of conversion: direct labour and machine costs, plus production overheads allocated on normal capacity. For bought-out processes, the job work charges.
- Other costs that bring the inventory to its present location and condition.
Excluded: abnormal wastage of materials, labour or overheads; storage costs (unless the process needs them, like maturing); administrative overheads; and selling costs. Abnormal loss goes to the profit and loss account in the period it happens. It doesn't sit in stock.
FIFO vs weighted average: a worked example
One raw material, one month. Prices are rising.
| Date | Movement | Quantity | Rate |
|---|---|---|---|
| 1 April | Receipt | 100 kg | ₹50 |
| 10 April | Receipt | 100 kg | ₹60 |
| 15 April | Issue to production | 120 kg | — |
| 20 April | Receipt | 100 kg | ₹70 |
| 25 April | Issue to production | 100 kg | — |
Total purchases: 300 kg costing ₹18,000. Total issued: 220 kg. Closing stock: 80 kg.
| Method | Cost of 15 April issue | Cost of 25 April issue | Total consumed | Closing stock (80 kg) |
|---|---|---|---|---|
| FIFO | ₹6,200 (100 × 50 + 20 × 60) | ₹6,200 (80 × 60 + 20 × 70) | ₹12,400 | ₹5,600 (at ₹70) |
| Moving weighted average | ₹6,600 (at ₹55.00) | ₹6,333 (at ₹63.33) | ₹12,933 | ₹5,067 (at ₹63.33) |
| Periodic weighted average | — | — | ₹13,200 (at ₹60.00) | ₹4,800 (at ₹60.00) |
Three things to notice:
- Every method adds up to ₹18,000. Consumption plus closing stock always equals what you paid. The method decides only when the cost hits your P&L.
- In rising prices, FIFO reports the highest closing stock and so the highest profit, because the oldest, cheapest stock is consumed first. In falling prices, it's the reverse.
- The periodic average can only be calculated at month end. The moving average gives a cost at the moment of each issue, which is what you need to cost a production order or know an invoice's margin the same day.
Which method should a manufacturer use?
| Consideration | FIFO | Moving weighted average |
|---|---|---|
| Matches physical flow | Yes, for perishable or dated stock | Not exactly, but fine for interchangeable materials |
| Effect of price swings | Passes them straight into consumption cost, batch by batch | Smooths them out |
| Effort to run | Must track the remaining quantity of every receipt layer | One running rate per item |
| Production costing | A single job can draw from several layers at different rates | Each issue carries one rate |
| Best for | Food, pharma and other dated stock | Most raw materials, components and finished goods |
For most SME manufacturers, the moving weighted average is the practical choice. It is what most manufacturing ERPs use by default. Each receipt updates the item's average; each issue goes out at the average of the moment. Where stock carries expiry dates, you still pick physically by first-expiry-first-out. That's a warehouse rule, separate from the costing method.
What about net realisable value?
NRV is the estimated selling price less the costs to complete and sell. If finished goods costing ₹420 a unit can now sell for only ₹380 after ₹15 of selling costs, NRV is ₹365, and the stock is written down by ₹55 a unit. Raw materials aren't written down if the finished goods they go into will still sell above cost. Review NRV at least at each year end, starting with slow-moving and obsolete items.
Why the closing stock figure matters so much
Gross profit is sales minus (opening stock + purchases + conversion − closing stock). Every rupee added to closing stock is a rupee added to profit, and to tax. An inflated figure overstates profit and tax. A deflated one understates them and invites questions from your auditor or the assessing officer. A stock figure that comes from a valuation ledger, where every receipt and issue is recorded at a rate, is far easier to defend than one typed in from a spreadsheet.
Pick one method, apply it to every movement as it happens, and your closing stock becomes a report rather than a year-end project.
How Dravyaa values inventory
With production costing switched on, Dravyaa values every stock movement at a moving weighted average per item. Goods receipts and bills come in at their document rate. Issues, transfers and sales go out at the average. Production receipts come in at the actual cost of the order. Each item has a valuation ledger showing every movement and its value. Closing stock in the profit and loss account and balance sheet is read from that ledger, as on any date you choose.
Frequently asked questions
Which inventory valuation methods are allowed in India?
AS 2, Ind AS 2 and ICDS II allow FIFO and weighted average cost for interchangeable items, and specific identification for items that are not ordinarily interchangeable. Inventory is measured at the lower of cost and net realisable value. LIFO is not allowed.
What is the difference between FIFO and weighted average?
FIFO assumes the oldest stock is used first, so consumption is costed at older prices and closing stock at recent ones. Weighted average costs every unit at the average price of the stock on hand. When prices are rising, FIFO gives a higher closing stock and profit.
What is the moving weighted average method?
The moving weighted average recalculates an item's average cost every time stock is received. Each issue goes out at the average at that moment, so every transaction has a cost the day it happens.
Is GST included in the cost of inventory?
No, not if you can claim it as input tax credit. GST that cannot be recovered is part of the cost.
Can I change my inventory valuation method?
Only if the change gives a more appropriate presentation or is required by law or a standard. It is a change in accounting policy and its effect must be disclosed. Apply your chosen method consistently from year to year.
Sources
Facts checked as of October 16, 2026. Rules change: confirm current requirements with the official source or your tax adviser.
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