Inventory valuation methods are the rules that decide which costs leave inventory as cost of goods sold and which costs stay in the inventory balance at the end of the period. Accountants also call them inventory costing methods. IAS 2 permits only three: specific identification, first in, first out (FIFO), and weighted average cost.
The method you choose does not change how many units sit in the warehouse. It changes the numbers on your income statement and your statement of financial position. In the worked SAR example in this guide, one item with the same purchases and the same sales produces a gross profit anywhere between SAR 4,728.89 and SAR 4,900, depending on which permitted method is used.
The guide explains each method, runs one example through all of them, and shows the journal entries. It then covers the lower of cost and net realizable value rule, what goes into inventory cost, what the disclosures require, and which method suits your business.
Inventory valuation, and why it changes your profit
Inventory valuation means setting the cost at which the stock left at the end of a period is carried. That figure feeds straight into cost of goods sold through this formula:
Cost of goods sold = Opening inventory + Purchases − Ending inventory
Opening inventory and purchases are known figures, taken from your books and supplier invoices. The figure that needs a decision is the value of ending inventory. The higher the value of what is left, the lower the cost of sales and the higher the gross profit. The reverse holds too. For a full walk-through of the formula, see how COGS is calculated.
That is why knowing the unit count is not enough. A business that bought the same item at three different prices during the month needs a rule for which price belongs to the units sold and which belongs to the units still on the shelf. That rule is the valuation method.
Inventory costing vs inventory valuation
Many accountants use inventory costing methods and inventory valuation methods to mean the same thing. Strictly, costing is about the cost of the units leaving the warehouse with each issue or sale. Valuation is about the value of the balance left at the date the financial statements are prepared.
The two are sides of one calculation: once you know the cost of what went out, you know the cost of what stayed. Valuation adds one step that costing does not cover. At the end of the period, cost is compared with net realizable value, and inventory is written down if that value is lower.
Inventory valuation methods permitted under IAS 2
IAS 2 Inventories sets out the acceptable cost formulas in paragraphs 23 to 27. Paragraph 13.18 of the IFRS for SMEs Accounting Standard says almost the same. There are three permitted methods, and each has its own use cases.
Specific identification
Specific identification assigns each unit its own actual cost. The standard requires it for items that are not ordinarily interchangeable, and for goods produced and segregated for specific projects (IAS 2.23).
Think of a car showroom that knows the chassis number and purchase price of every car, or a contractor that prepares materials for one named project and keeps them apart. In these cases the cost of the actual car sold goes out: not an average, and not the oldest price.
The standard rules this method out for large numbers of interchangeable items (IAS 2.24). With identical units, the business could pick which unit to sell and which to keep, and steer its profit that way.
First in, first out (FIFO)
The FIFO method assumes the units bought or produced first are the ones sold first. Inventory left at the end of the period is therefore carried at the cost of the most recent purchases (IAS 2.27).
It suits items that physically move in that order, such as food, medicines and cosmetics. When prices are rising, it gives the lowest cost of sales and the highest gross profit of the permitted methods, because the older, cheaper prices go out first.
Weighted average cost
The weighted average cost method costs each unit at the average cost of similar units available: those on hand at the start of the period and those bought or produced during it. The average is weighted by quantity, so a larger shipment moves it more.
IAS 2.27 allows the average to be worked out in two ways, depending on the business’s circumstances: once for the whole period, or each time a shipment is received. The IFRS Foundation’s educational material calls the first the periodic average cost method and the second the perpetual (moving) average cost method. The worked example shows that the two give different numbers.
Last in, first out (LIFO): why it is not used
LIFO assumes the last units bought are the first ones sold, so inventory is left at the oldest costs. Neither IAS 2 nor the IFRS for SMEs Standard permits it.
The IFRS for SMEs Standard prohibits it in so many words in paragraph 13.18. IAS 2.25 limits the permitted formulas to FIFO and weighted average, and LIFO is not among them. The IFRS Foundation’s educational material explains why: ending inventory shows the oldest costs, which generally does not represent the actual flow of inventory.
The worked example includes LIFO figures for comparison only, because readers meet the method in university textbooks and US references.
Standard cost and the retail method
IAS 2 allows standard cost or the retail method for convenience, provided the results approximate actual cost (IAS 2.21 and 2.22). Both are measurement shortcuts, not alternatives to the three methods. A factory that uses standard costs reviews them regularly so they stay close to reality.
Worked example: one item through January
The figures below are illustrative, built to explain the methods, not data from a real business. A trading business in Riyadh sells one item, a carton of paper tissues, at a fixed selling price of SAR 35 a carton. All amounts are before VAT to keep the example simple.
| Date | Movement | Quantity | Unit cost | Total |
|---|---|---|---|---|
| 1 January | Opening balance | 100 | SAR 20 | SAR 2,000 |
| 5 January | Purchase | 200 | SAR 22 | SAR 4,400 |
| 12 January | Sale | 250 | Selling price SAR 35 | Revenue SAR 8,750 |
| 20 January | Purchase | 150 | SAR 25 | SAR 3,750 |
| 28 January | Sale | 130 | Selling price SAR 35 | Revenue SAR 4,550 |
The month in summary, before applying any method:
- Units available for sale: 450 cartons (100 + 200 + 150).
- Cost of goods available for sale: SAR 10,150 (2,000 + 4,400 + 3,750).
- Units sold: 380 cartons, leaving 70 cartons in the warehouse.
- Sales revenue: SAR 13,300 (380 × 35).
Each method splits the SAR 10,150 between cost of sales and ending inventory. The total does not change. The split does.
Solving it with FIFO
Under FIFO the oldest units go out first. The 380 cartons sold come from the opening balance, then from the 5 January shipment, then from part of the 20 January shipment.
- 100 cartons from the opening balance × SAR 20 = SAR 2,000
- 200 cartons from the 5 January shipment × SAR 22 = SAR 4,400
- 80 cartons from the 20 January shipment × SAR 25 = SAR 2,000
Cost of goods sold = SAR 8,400. The 70 cartons left in the warehouse come from the 20 January shipment, so ending inventory = 70 × 25 = SAR 1,750. Gross profit = 13,300 − 8,400 = SAR 4,900.
Does the answer change if you cost each sale as it happens?
Not in this example. Costing each sale as it happens, the 12 January sale takes 100 cartons at 20 and 150 cartons at 22, which is SAR 5,300, and leaves 50 cartons at 22.
After the 20 January shipment arrives, the 28 January sale takes the remaining 50 cartons at 22 (SAR 1,100), then 80 cartons at 25 (SAR 2,000). The two sales together cost 5,300 + 3,100 = SAR 8,400, and 70 cartons at 25 = SAR 1,750 remain. Both figures match the month-end calculation.
Solving it with weighted average: periodic and perpetual
This is where the difference IAS 2.27 points to shows up. The same business gets two different answers depending on when it works out the average.
Periodic weighted average (once, at month end)
Average cost per carton = cost of goods available ÷ units available = 10,150 ÷ 450 = about SAR 22.5556.
- Cost of goods sold: 380 × 22.5556 = SAR 8,571.11
- Ending inventory: 70 × 22.5556 = SAR 1,578.89
- Gross profit: 13,300 − 8,571.11 = SAR 4,728.89
The figures use the unrounded average and are then rounded to two decimals. 8,571.11 + 1,578.89 comes to exactly SAR 10,150.
Perpetual weighted average (after each shipment)
Under the perpetual average, the average cost is recalculated after every purchase, and each sale goes out at the average in place on the day of the sale.
- After the 5 January purchase: 300 cartons costing SAR 6,400, an average of SAR 21.3333.
- 12 January sale: 250 × 21.3333 = SAR 5,333.33 cost of sales. 50 cartons remain, costing SAR 1,066.67.
- After the 20 January purchase: 200 cartons costing 1,066.67 + 3,750 = SAR 4,816.67, a new average of SAR 24.0833.
- 28 January sale: 130 × 24.0833 = SAR 3,130.83 cost of sales.
- Remaining: 70 cartons costing SAR 1,685.83.
Cost of goods sold under the perpetual average = 5,333.33 + 3,130.83 = SAR 8,464.17. Ending inventory = SAR 1,685.83. Gross profit = 13,300 − 8,464.17 = SAR 4,835.83.
The figures use the unrounded average and are then rounded to two decimals, so cost of goods sold (SAR 8,464.17) is one halala above the sum of the two rounded sale costs (5,333.33 + 3,130.83 = 8,464.16). Cost of goods sold plus ending inventory, 8,464.17 + 1,685.83, comes to exactly SAR 10,150.
The two averages differ by SAR 106.94 in cost of sales, for one item in one month. The 12 January sale went out at an average of 21.33, before the dearer shipment arrived. The periodic average, by contrast, loaded part of the SAR 25 price onto every sale.
If LIFO were applied: figures for comparison only
These figures only show why the method is barred. They cannot be used in financial statements prepared under IFRS. On a periodic basis, sales come from the newest shipments first:
- 150 cartons from the 20 January shipment × 25 = SAR 3,750
- 200 cartons from the 5 January shipment × 22 = SAR 4,400
- 30 cartons from the opening balance × 20 = SAR 600
Cost of sales is SAR 8,750, ending inventory is 70 × 20 = SAR 1,400, and gross profit is SAR 4,550. The remaining stock is carried at SAR 20 a carton, although the last purchase cost SAR 25. This is the reason the IFRS Foundation’s educational material gives for the ban: inventory carried at the oldest costs generally does not represent the actual flow of goods.
Comparing the results: cost of sales, inventory and gross profit
The SAR 10,150 total is the same under every method. What changes is the part that moves to the income statement. In this example prices rose during the month from 20 to 22 to SAR 25, which produced three results:
- FIFO gave the highest gross profit (SAR 4,900) and the highest inventory (SAR 1,750), because the older, cheaper prices went to cost of sales.
- Weighted average landed in the middle, and its perpetual version (SAR 4,835.83) came closer to FIFO than the periodic one (SAR 4,728.89).
- LIFO gave the lowest profit and the lowest inventory, and it is not permitted in the first place.
Had prices fallen during the period, the order would flip and FIFO would give the lowest profit. Over the long run the method creates no profit or loss of its own. It spreads the same cost across periods on a different timetable.
Inventory valuation journal entries for the example
The entries below follow the perpetual inventory system, where cost of sales is recorded with every sale. Amounts are before VAT, and purchases are on credit.
The 5 January purchase entry
| Account | Debit | Credit |
|---|---|---|
| Inventory Account | 4,400 | |
| Suppliers Account | 4,400 |
The two entries for the 12 January sale
A sale needs two entries: one for revenue and one for cost of sales. The revenue entry is the same under every method:
| Account | Debit | Credit |
|---|---|---|
| Customers Account | 8,750 | |
| Sales Account | 8,750 |
The amount of the cost entry depends on the method. Under FIFO it is SAR 5,300, and under the perpetual weighted average it is SAR 5,333.33:
| Account | Debit (perpetual average) | Credit (perpetual average) |
|---|---|---|
| Cost of Goods Sold Account | 5,333.33 | |
| Inventory Account | 5,333.33 |
Entries under the periodic inventory system
Under the periodic inventory system no cost entry is posted with each sale. Purchases go to a purchases account during the month. At month end a physical count is taken, and ending inventory is recorded using the chosen method.
Under the periodic weighted average, ending inventory is recorded at SAR 1,578.89. Cost of sales then follows from the formula: 2,000 + 8,150 purchases − 1,578.89 = SAR 8,571.11, the same figure calculated earlier. Any gap between book and counted quantities is dealt with through inventory adjusting entries before valuation.
Lower of cost and net realizable value
Once cost is set using one of the methods, IAS 2 adds a second step: inventory is measured at the lower of cost and net realizable value (IAS 2.9). Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs needed to make the sale (IAS 2.6).
The standard lists reasons cost may not be recoverable: the goods are damaged, they are wholly or partly obsolete, their selling price has fallen, or the costs to complete or sell them have risen (IAS 2.28). Write-downs are usually made item by item, and grouping similar items in one product line can be appropriate. Writing down a whole class, such as all finished goods, is not (IAS 2.29).
Write-down example: end of January
We continue the same example under the perpetual weighted average. On 31 January a competitor’s promotion pushes the market price of a carton down to SAR 24, and the estimated selling cost is SAR 1.50 a carton.
Net realizable value per carton = 24 − 1.50 = SAR 22.50, and for the 70 cartons it is SAR 1,575. The carrying cost is SAR 1,685.83, so inventory is written down by the difference, SAR 110.83.
| Account | Debit | Credit |
|---|---|---|
| Inventory Write-down Losses Account | 110.83 | |
| Inventory Account | 110.83 |
The write-down is an expense in the period it occurs (IAS 2.34). Some businesses keep a separate account for it, as in the entry above, and others charge it to cost of goods sold. Either way, the amount must appear in the disclosures.
Notice how the valuation method changes the write-down itself. Under FIFO the cost was SAR 1,750, so the write-down becomes SAR 175. Under the periodic average the cost was SAR 1,578.89, so the write-down is only SAR 3.89.
Reversing the write-down when the price recovers
Net realizable value is reassessed every period. If the reason for the write-down no longer exists, it is reversed, but never by more than the original write-down (IAS 2.33), and the reversal reduces the inventory expense in the period it happens (IAS 2.34).
Say the 70 cartons were not sold, and in February the price returns to SAR 27 with a selling cost of SAR 1.50. The new net realizable value is 25.50 × 70 = SAR 1,785. Inventory is not raised to 1,785. The write-down is reversed in full, at SAR 110.83 only, which brings inventory back to its cost of SAR 1,685.83. The entry is the write-down in reverse: debit Inventory Account, credit Inventory Write-down Losses Account.
One exception matters for manufacturers: raw materials held for production are not written down if the finished product they go into will sell at or above cost (IAS 2.32).
What goes into inventory cost, and what stays out
Every valuation method works on the cost figure you record. If that figure is incomplete or inflated, no method will fix it. IAS 2 builds inventory cost from three parts: costs of purchase, costs of conversion, and other costs incurred to bring the inventory to its present location and condition (IAS 2.10).
What is included in cost
- The purchase price, after deducting trade discounts and rebates (IAS 2.11).
- Import duties and non-recoverable taxes, meaning taxes the business does not later recover.
- Transport and handling, and any other cost directly attributable to bringing the goods in.
- Conversion costs in factories: direct labour plus a systematic share of fixed and variable production overheads. Fixed overheads are allocated on the basis of normal production capacity (IAS 2.12 and 2.13).
It follows from paragraph 11 that VAT the business recovers as input tax is not part of inventory cost, because the standard excludes taxes the business later recovers. If the tax cannot be recovered, it is part of cost.
What is excluded and expensed
- Abnormal waste of materials or labour.
- Storage costs, unless they are necessary in production before a further stage.
- Administrative overheads that do not help bring inventory to its present location and condition.
- Selling costs (IAS 2.16).
- The financing element of a deferred-payment purchase, which is interest expense, not inventory cost (IAS 2.18).
A practical case: if the business in the example paid SAR 300 in freight for the 5 January shipment, that shipment’s cost rises to SAR 4,700 and the cost per carton to SAR 23.50. Rent on the warehouse holding goods that are ready for sale, on the other hand, is an expense of the period and is not added to the cost of the carton.
The consistency rule: one method for similar items
IAS 2.25 requires the same cost formula for all inventories of a similar nature and use. Inventories that differ in nature or use may justify different formulas.
Take a business that values its food lines on FIFO and the spare parts for its equipment on weighted average. That is acceptable, because the two categories differ. Valuing the same food lines one way in its Jeddah branch and another way in its Dammam branch is not. The standard states that a difference in geographical location, or in tax rules, is not by itself enough to justify a different formula (IAS 2.26).
The choice of method is part of the business’s accounting policies, and disclosing it is mandatory. So the method is not switched from one year to the next to improve profit. Comparing years loses its meaning once the basis of measurement changes.
Which standard applies to your business in Saudi Arabia?
According to the IFRS Foundation’s jurisdiction profile for Saudi Arabia, compiled from the responses of the Saudi Organization for Chartered and Professional Accountants (SOCPA), publicly accountable entities, including listed companies, apply IFRS Accounting Standards as endorsed in the Kingdom.
Small and medium-sized entities, as defined in the IFRS for SMEs Standard, apply the version endorsed for them. They may choose full endorsed IFRS instead, provided they apply it in full and keep applying it. The profile states that SOCPA’s changes were mostly additional disclosures, and it records no change to inventory cost formulas.
The practical result is the same in both cases: specific identification for items that are not interchangeable, FIFO or weighted average for the rest of the inventory, and no LIFO. For the wider context of the standards, see our guide to international accounting.
Required inventory disclosures in the financial statements
IAS 2.36 requires the business to disclose the following in the notes to its financial statements:
- The accounting policy for measuring inventories, including the cost formula used.
- The total carrying amount of inventories, and the carrying amount in classifications that suit the business.
- The carrying amount of inventories carried at fair value less costs to sell, if any.
- The amount of inventories recognised as an expense during the period.
- The amount of any write-downs, and of any reversals of write-downs together with the circumstances that led to them.
- The carrying amount of inventories pledged as security for liabilities.
The IFRS for SMEs Standard asks for a shorter list in paragraph 13.22: the policy and cost formula, the carrying amounts, the amount expensed, impairment losses recognised or reversed, and inventory pledged as security. In our example, the business would disclose the method it uses, the SAR 1,575 balance after the write-down, and the SAR 110.83 impairment loss.
Which inventory valuation method should your business use?
The nature of your items decides which method fits: specific identification for items that are not interchangeable, and FIFO or weighted average for items that are (IAS 2.23 and 2.25). So the first question is whether you can tell each unit apart from the others. If the items are interchangeable, the choice is between the other two methods.
When FIFO fits
FIFO suits a business in these cases:
- Goods genuinely leave in the order they arrive, as with food, medicines and products that carry an expiry date.
- You want the inventory balance on the statement of financial position to sit close to the latest purchase prices.
- Shipments are few, or you have a system that tracks each shipment and the quantity left from it.
When weighted average fits
Weighted average suits a business in these cases:
- Units mix in the warehouse and one shipment cannot be separated from another, as with fuel, grain and bulk materials.
- Purchase prices swing up and down, and you want a steadier cost of sales from month to month.
- You want a simpler calculation that does not track shipment layers.
If you choose weighted average, decide when the average is calculated. The perpetual average gives the cost of each sale at the time it happens, but it needs every purchase recorded as soon as it occurs. The periodic average is worked out after the period closes, so you do not know the exact cost of sales until the period ends.
Do not base the choice on the profit you would like to show. The first-year difference fades over time, and the method you pick today becomes part of your accounting policy for the years that follow. Nor should you pick a method your accounting system cannot apply every day. Applying it outside the system means side spreadsheets that disagree with the books.
Common inventory valuation mistakes
- Valuing inventory without a physical count. The method works on book quantities. If damaged or missing stock has not been recorded, the inventory value is wrong whatever the method. Valuation starts with a count; our guide to what inventory is covers the basics.
- Ignoring the net realizable value rule. Slow-moving stock, or stock sold at deep discounts, stays at cost in the books, which inflates both inventory and profit.
- Adding selling and storage costs to cost. A sales rep’s commission and showroom rent are expenses of the period, not part of the item’s cost.
- Leaving out freight and customs. The opposite is also a mistake. Import duties and freight to the warehouse are part of cost, and expensing them straight away understates inventory and overstates expenses.
- Mixing the periodic and perpetual averages. Working some months one way and other months the other way makes cost of sales impossible to compare.
- Writing down a whole class instead of individual items. A price drop on one item does not justify writing down all inventory, and a price rise on one item does not offset a drop on another.
To work out cost of sales quickly from opening and ending balances and purchases, use the COGS calculator.
How Qoyod calculates your inventory cost
Qoyod accounting software uses the average cost method to cost inventory, and calculates the average cost of each product in each location automatically.
- Where average cost comes from: Qoyod calculates it from purchase invoices, opening balances, stocktakes and stock transfers between locations. Any delay in recording these transactions therefore shows up in the figure.
- Average cost per location: on the «المنتجات والتكاليف» (products and costs) screen, choose «عرض» (view) next to the product, then click the location name to see the product’s movements in that location and its average unit cost. If the product’s quantity in the location is zero, no average appears, because there is no quantity to cost.
- Stock transfers between locations at cost: when you move a quantity from one warehouse to another, the average cost in the receiving warehouse is affected by the product’s average cost in the warehouse it came from. This helps if you run several branches.
- The product cost and profit margin report («تقرير تكلفة المنتج وهامش الربح»): shows quantity on hand, average unit cost, net selling price, profit margin and margin percentage for each product, category or location, with the margin calculated from average unit cost.
- Total inventory value: in the account statement report («كشف الحساب»), choose the inventory account and a period, and filter the result by branch or warehouse.
- Stocktakes for damaged and missing stock: you record the difference between book and counted quantities, and the system creates a journal entry for the difference automatically. This step comes before any judgement on net realizable value.
Report details are on the real-time financial reports page, and the features built for owners are on the accounting for business owners page.
Plan note: stocked products, stocktakes, stock transfers and purchase invoices are available from the Pro plan up. The free trial runs on the Basic plan, so tracking inventory cost in Qoyod starts once you subscribe to the Pro plan or above.
Frequently asked questions
What are the inventory costing methods?
IAS 2 permits three inventory costing methods: specific identification for items that are not interchangeable, and FIFO or weighted average for the rest of the inventory (IAS 2.23 and 2.25). LIFO is not permitted under IFRS or under the IFRS for SMEs Standard.
How do I determine the value of my inventory?
Inventory is valued in three steps. Start with a physical count to establish the quantity left, then apply your business’s cost formula to that quantity. Next, compare cost with net realizable value for each item and record inventory at the lower of the two (IAS 2.9). The result is the inventory figure on the statement of financial position.
What are FIFO and LIFO?
FIFO is first in, first out: the oldest units are sold first, so inventory is left at the most recent costs. LIFO is last in, first out: the newest units are sold first, so inventory is left at the oldest costs. FIFO is permitted under IAS 2, and LIFO is not.
How is inventory valued using the weighted average method?
Divide the cost of goods available by the number of units available to get the average cost per unit, then multiply it by the units left. In this guide’s example: 10,150 ÷ 450 = SAR 22.5556, and 70 cartons × 22.5556 = SAR 1,578.89. If you recalculate the average after each shipment, you get SAR 1,685.83.
Is LIFO allowed in Saudi Arabia?
LIFO is not allowed in Saudi Arabia if your financial statements are prepared under IFRS as endorsed in the Kingdom or under the endorsed IFRS for SMEs Standard. The IFRS for SMEs Standard prohibits it in paragraph 13.18, and IAS 2 limits interchangeable items to FIFO and weighted average.
Can one business use more than one inventory valuation method?
Yes, provided the categories of inventory differ in nature or use. IAS 2.25 requires one formula for all inventories of a similar nature and use. A different geographical location or different tax rules do not by themselves justify a different formula for the same item (IAS 2.26).
Which inventory valuation method does Qoyod use?
Qoyod uses the average cost method only, and calculates the average automatically from purchase invoices, opening balances, stocktakes and stock transfers between locations. Stocked products are available from the Pro plan up.
