Inventory Valuation
Why two companies holding the exact same 1,000 sacks of rice in their warehouse can report two different profit numbers — just from how they count the cost of what was sold.
In plain English
Imagine you run a small shop selling rice. In January, you buy 100 sacks at ₹1,000 each. In June, rice prices rise, and you buy another 100 sacks at ₹1,300 each. By December, you've sold 150 sacks, and 50 are still sitting in your warehouse.
Here's a question that sounds simple but genuinely isn't: which 150 sacks did you sell — the cheap January ones, the expensive June ones, or a bit of both? You can't tell just by looking; a sack bought in January looks identical to one bought in June. Yet the answer changes your reported profit, your tax bill, and the value of what's sitting in your warehouse — by a meaningful amount, on the exact same pile of rice. Inventory valuation is the set of rules that decides which cost gets attached to what you sold, and which cost stays behind in what you're still holding.
Words you'll need first
Simply the cost of whatever inventory was sold during the year — it gets subtracted from revenue to arrive at gross profit. The tricky part, as the rice example shows, is deciding WHICH cost (the ₹1,000 sacks or the ₹1,300 sacks) counts as 'sold'. That decision is exactly what inventory valuation methods like FIFO and Weighted Average exist to settle.
The estimated price an item could actually be sold for, minus whatever it will still cost to finish and sell it — packaging, shipping, a salesperson's commission. It matters because of a firm accounting rule: inventory can never be shown on the balance sheet at more than what it's actually worth today. If a company paid ₹1,300 for a sack of rice that, because of a bumper harvest, can now only be sold for ₹900, the accounts must write it down to ₹900 — a company is never allowed to keep pretending stock is worth what it originally paid for it.
Two accepted ways to decide 'which cost sold'
FIFO — First In, First Out
Assumes the OLDEST stock is sold first, exactly like a grocer selling older milk cartons before newer ones so nothing expires on the shelf. In the rice example: the 150 sacks sold are treated as the 100 January sacks (₹1,000 each) plus 50 June sacks (₹1,300 each) — COGS = ₹1,65,000. The 50 sacks left in the warehouse are valued at the more recent, higher June price: 50 × ₹1,300 = ₹65,000. In a period of rising prices, FIFO pushes cheaper old costs into COGS, meaning higher reported profit and a closing inventory value closer to current market prices.
Weighted Average
Blends all the costs into one average cost per unit, and applies that same average to everything sold AND everything left. In the rice example: total cost ₹2,30,000 spread over 200 sacks = ₹1,150 average per sack. COGS for 150 sacks sold = ₹1,72,500. Closing inventory for the 50 sacks left = ₹57,500. This method smooths out price swings — no single batch of costs gets singled out, so profit tends to sit between what FIFO and LIFO would show.
Before vs. now
How it used to happen
Older Indian GAAP (the pre-Ind AS 'AS 2', and looser practice before that) left companies more discretion. Inventory could sometimes be carried at cost even after its market value had clearly fallen, write-downs were applied inconsistently from company to company, and a company could also choose LIFO if it wanted to — which, in a period of rising prices, pushes MORE cost into COGS and shows LOWER profit and a lower closing inventory value than FIFO.
How it's done now
Ind AS 2 tightened this considerably. Two rules are now non-negotiable. First, inventory must always be shown at the LOWER of cost and Net Realisable Value — if market value has fallen below what was paid, the write-down must be taken immediately, with no discretion involved. Second, LIFO is no longer permitted at all under Ind AS or IFRS; a company must use either FIFO or Weighted Average, pick one, and apply it consistently period after period.
A worked example, with numbers
| Method | 150 sold, treated as costing | COGS (expense) | Closing inventory value |
|---|---|---|---|
| FIFO | 100 @ ₹1,000 + 50 @ ₹1,300 | ₹1,65,000 | ₹65,000 |
| Weighted Average | 150 @ ₹1,150 (blended) | ₹1,72,500 | ₹57,500 |
- Same 200 sacks bought, same 150 sacks sold, same 50 sacks left — but FIFO shows ₹7,500 LOWER cost of goods sold (and therefore ₹7,500 HIGHER gross profit) than Weighted Average, purely from the choice of method.
- FIFO's closing inventory value (₹65,000) is also higher than Weighted Average's (₹57,500), because FIFO values the leftover stock at the most recent, higher purchase price.
- If rice prices had FALLEN instead of risen during the year, these effects would flip — FIFO would show the higher cost of goods sold and lower profit of the two methods.
- Now add the NRV rule: if by year-end rice could only be resold at, say, ₹1,100 a sack after selling costs, FIFO's closing inventory of ₹65,000 (valued at ₹1,300/sack) would have to be written down to ₹55,000 (50 × ₹1,100) — an extra hit straight to the P&L, regardless of which method was used to get there.
What it does to the financial statements
Impact on the P&L
- The valuation method chosen (FIFO vs Weighted Average) directly changes Cost of Goods Sold, and therefore gross profit and net profit — on the exact same physical stock and the exact same sales.
- In a period of rising input costs, FIFO typically shows lower COGS and higher profit than Weighted Average; in a period of falling costs, this reverses.
- Any write-down to Net Realisable Value hits the P&L immediately as an expense, usually flowing through cost of goods sold, even though no inventory was actually sold — it is simply marking stock down to what it's really worth.
- A large, one-off inventory write-down is a common reason a company's gross margin suddenly drops in a particular quarter, especially in fashion, electronics, or commodity-linked businesses where prices or trends move fast.
Impact on the Balance Sheet
- Inventory sits under current assets, valued at the lower of cost and Net Realisable Value — never above what it can realistically be sold for.
- FIFO tends to show a HIGHER closing inventory value on the balance sheet than Weighted Average during periods of rising prices, since it carries the most recent, higher purchase costs forward.
- A large or growing inventory balance relative to sales (best tracked using Inventory Days or Inventory Turnover) can be an early warning sign of unsold or slow-moving stock, well before it shows up as a formal write-down.
- Inventory write-downs reduce the asset's carrying value on the balance sheet, with the matching expense hitting the P&L in the same period — assets and profit move together, not independently.
Which standard covers this
In India this is governed by Ind AS 2 – Inventories, notified under the Companies (Indian Accounting Standards) Rules, applicable to companies that follow Ind AS. Companies that instead follow the older Indian GAAP framework apply the equivalent AS 2.
How it's recognised globally
Globally, the equivalent is IAS 2, issued by the International Accounting Standards Board — Ind AS 2 is closely aligned with it, including the ban on LIFO and the mandatory lower-of-cost-and-NRV rule. The United States is the major exception again: under US GAAP (ASC 330), LIFO remains fully permitted, and is still commonly used by large American manufacturers, retailers, and oil companies — mainly because US tax law allows LIFO to reduce taxable income during inflationary periods, through a rule called the 'LIFO conformity rule', which requires a company to use LIFO in its financial statements if it wants to use LIFO for tax purposes. This means an Indian company and a comparable American company holding identical inventory can report meaningfully different cost of goods sold and profit, purely because Indian rules force FIFO or Weighted Average while US rules allow LIFO — something to keep in mind whenever comparing margins of an Indian company against a US peer in the same industry.
Real example — Indian listed company
Steel and metal companies are where inventory valuation stops being a footnote and starts genuinely moving the reported numbers. A company like Tata Steel buys iron ore and coking coal and holds them for weeks before turning them into finished steel and selling it — so the raw-material cost embedded in its inventory is constantly interacting with swinging global commodity prices. When raw material prices are RISING, the mechanics explained in this article mean older, cheaper material flows into cost of goods sold that quarter, flattering margins — commonly called an 'inventory gain' in results commentary. When prices are FALLING, the reverse happens: margins get squeezed, or the company may even have to book an inventory write-down to Net Realisable Value, because the raw material or finished steel it's holding is worth less on paper than what it cost to produce. This is precisely why metals and steel companies' quarterly earnings calls routinely flag 'inventory gain' or 'inventory loss' as a swing factor — it's one of the first adjustments analysts make to see a metals business's underlying operating performance, separate from what commodity prices happened to do that quarter.
Where you'll see this
Related concepts
Depreciation Methods
Why the exact same ₹10 crore machine can show a different profit impact every year for a decade, depending on nothing more than which depreciation method a company picked on day one.
Borrowing Costs Capitalisation
Why the interest a company pays on a loan taken to build a new factory doesn't always show up as an 'interest expense' in the P&L — sometimes it quietly becomes part of the factory's cost instead.
Impairment of Property, Plant & Equipment
Why a factory that's still running, still making products, and hasn't broken down at all can suddenly be written down by thousands of crores on a company's balance sheet — with nothing physically wrong with the building or the machines.