FIFO vs Average Cost: Choosing an Inventory Method for a Small Business

A shop buys the same item three times in a quarter, each time at a higher price. Then it sells some. What did those units cost? The answer changes the profit reported for the period and the value of the stock still on the shelf. The choice between FIFO vs average cost is the choice of how to answer that question, and it matters most when prices move.

Why a method is needed

If every unit were bought at the same price, there would be nothing to decide. In practice, purchase prices change. Once units from different purchases are mixed on a shelf, you usually cannot tell which specific unit a customer took. An inventory costing method is an agreed assumption about which costs are charged to sales first.

Two figures depend on it:

• Cost of goods sold, which reduces profit for the period.
• Closing inventory value, which appears as an asset.

Whatever is not charged to cost of goods sold remains in inventory. The total is the same under any method. Only the split differs.

One example, two methods

A shop makes these purchases:

• 1 March: 100 units at Rp 10,000 = Rp 1,000,000
• 15 March: 100 units at Rp 12,000 = Rp 1,200,000
• 28 March: 100 units at Rp 14,000 = Rp 1,400,000

Total: 300 units costing Rp 3,600,000. During the month it sells 180 units, leaving 120.

FIFO: first in, first out

The earliest costs are charged first.

• Cost of the 180 sold: the first 100 at 10,000 plus 80 at 12,000 = 1,000,000 + 960,000 = Rp 1,960,000.
• Closing stock of 120: 20 at 12,000 plus 100 at 14,000 = 240,000 + 1,400,000 = Rp 1,640,000.

Average cost

Every unit carries the average cost of all units available.

• Average: 3,600,000 / 300 = Rp 12,000 per unit.
• Cost of the 180 sold: 180 x 12,000 = Rp 2,160,000.
• Closing stock of 120: 120 x 12,000 = Rp 1,440,000.

In practice the average is recalculated after each purchase, which is called moving average. The example above uses a single period average to keep the arithmetic visible.

The difference

If the 180 units sold for Rp 20,000 each, sales are Rp 3,600,000.

• Gross profit under FIFO: 3,600,000 - 1,960,000 = Rp 1,640,000.
• Gross profit under average: 3,600,000 - 2,160,000 = Rp 1,440,000.

Same goods, same sales, a difference of Rp 200,000 in reported profit. When prices are rising, FIFO shows higher profit and higher stock value, because older, cheaper costs go to sales and newer, dearer costs stay in stock. When prices fall, the effect reverses.

How FIFO behaves

Strengths

• Closing stock is valued at recent prices, close to replacement cost.
• It matches the physical flow of most goods, especially perishables and dated products.
• It is widely accepted under accounting standards.

Weaknesses

• It requires tracking purchase batches, or layers, with their costs.
• When prices rise, reported profit is higher, which can mean more tax and a margin that looks better than the cost of restocking suggests.

How average cost behaves

Strengths

• Simple. One cost per item at any time.
• It smooths price swings, so margins move less from month to month.
• It suits goods that are interchangeable and mixed together: grain, fuel, screws, liquids.

Weaknesses

• Stock value lags behind current prices.
• A sharp price change is absorbed slowly, which can hide the need to reprice.

What about LIFO?

Last in, first out charges the newest costs to sales first. It is not permitted under international accounting standards, and many countries do not allow it. Small businesses outside the few jurisdictions that accept it should not use it.

How to choose

Ask four questions.

1. What do you sell? Perishable, dated or batch-tracked goods fit FIFO naturally. Interchangeable goods that are mixed in storage fit average cost.
2. How volatile are your purchase prices? With stable prices the two methods give almost the same result. Choose the simpler one.
3. What does your system support? A method your software handles automatically is better than a superior one maintained by hand.
4. What do the rules require? Tax and accounting rules in your country may limit the choice or require you to stay with the method you pick. Check with an accountant.

Then be consistent. Changing methods back and forth makes profit figures incomparable and is generally not allowed without good reason.

Costing is only part of inventory control

A method values stock. It does not keep it accurate. Good practice around it:

• Record every movement. Receipts, sales, returns, transfers, damage, samples.
• Include all purchase costs in the unit cost: freight, duty and handling, not only the supplier's price.
• Count regularly. A full count at least yearly, with rotating counts of key items in between.
• Investigate differences. A gap between records and count is caused by error, damage or theft. Find out which.
• Write down stock that cannot be sold at its recorded cost: expired, damaged or obsolete items.
• Watch slow movers. Stock that sits is cash that cannot be used.

Pricing follows cost

Whichever method you use, the cost it produces feeds your margin calculations. In a period of rising prices, remember that the cost in your books may be below what it will cost to replace the item. Price for replacement, or the next purchase will be funded from your margin.

Tools

A spreadsheet can hold a moving average for a handful of items. FIFO layers by hand become unmanageable beyond that. Inventory and bookkeeping software applies the chosen method to each sale and posts cost of goods sold automatically. Polynusa keeps stock, sales and bookkeeping in one workspace, so the cost of each sale reaches the books without re-entry. See the pricing page.

Summary

FIFO charges the oldest costs to sales first and values stock at recent prices. Average cost gives every unit the same blended cost and smooths changes. They differ only when prices move. Choose by the nature of your goods, your system and local rules, apply the method consistently, and count stock regularly.

FAQ

Does FIFO mean we must physically sell the oldest stock first?

Selling older stock first is good practice, especially for perishables, but the accounting method is a separate matter. FIFO as a costing method assumes that the earliest purchase costs are the first to be charged to sales, whatever physically left the shelf.

Can a business change its inventory method later?

It can, and it should not be done casually. Changing methods alters reported profit and stock value and makes years hard to compare. Tax and accounting rules in most countries expect consistency and may require disclosure or approval, so consult an accountant before changing.

How often should stock be counted?

A full count at least once a year, and more often for valuable or fast-moving items. Many businesses count a few items every week on rotation, known as cycle counting, so that differences are found soon after they occur.