FIFO or weighted average: choosing a stock costing method

You buy inventory at different prices throughout the year, but you sell it at a single retail price. When a customer buys an item, you must decide which of those varying purchase costs to deduct from your revenue to calculate your profit. This choice between costing methods changes your financial reports without changing your physical stock.

Setting up the scenario: two purchases and one sale

Let us look at a simple scenario to see exactly how your choice of costing method changes your numbers. Imagine you sell desk lamps. You make two purchases from your wholesale supplier early in the year.

• On January 10, you buy 100 lamps at $10 each. Your total cost for this first batch is $1,000.
• On March 15, supplier prices go up. You buy another 100 lamps for $15 each. Your total cost for this second batch is $1,500.

You now have 200 lamps sitting in your warehouse. Your total investment in this physical stock is $2,500.

In April, you sell 120 lamps to a corporate client for $25 each. You issue a standard tax invoice for $3,000.

Your total revenue is $3,000. To figure out your profit on this transaction, you need to subtract the cost of those 120 lamps. But which cost do you use: the $10 from January or the $15 from March? This is exactly where stock costing methods come into play.

Calculating profit using FIFO

The First-In, First-Out method assumes that the first items you placed into your inventory are the very first items you sell. This approach mimics the physical flow of goods in most businesses, especially those selling perishable items or products prone to obsolescence.

Under this method, we fulfill the 120-lamp order by completely emptying the oldest batch first, and then taking the remainder from the newer batch.

• 100 lamps come from the January batch at $10 each. This equals $1,000.
• The remaining 20 lamps come from the March batch at $15 each. This equals $300.

Adding these together, your total cost of goods sold is $1,300.

To calculate your gross margin, you subtract this $1,300 cost from your $3,000 revenue. Your profit under this method is $1,700.

You are left with 80 lamps in your warehouse. Because they are all from the March batch, your remaining inventory value on your balance sheet is $1,200 (calculated as 80 lamps multiplied by $15).

Calculating profit using weighted average

The weighted average method ignores the specific batches entirely. Instead, it blends the cost of all available units into a single average price before a sale takes place.

To find this average, you divide the total cost of goods available for sale by the total number of units available.

• Total cost of all lamps: $2,500.
• Total number of lamps: 200.
• Average cost per lamp: $2,500 divided by 200 equals $12.50.

When you sell the 120 lamps, you multiply that quantity by the average cost of $12.50. Your total cost of goods sold is $1,500.

Subtracting this $1,500 cost from your $3,000 revenue leaves you with a profit of $1,500.

You still have 80 lamps left in your warehouse. Valued at the average cost of $12.50 each, your remaining inventory value on your balance sheet is $1,000.

Why neither calculation is wrong

Looking at the results side by side reveals a significant difference.

Metric	First-In, First-Out	Weighted Average	Difference
Revenue	$3,000	$3,000	$0
Cost of Goods Sold	$1,300	$1,500	$200
Gross Profit	$1,700	$1,500	$200
Remaining Stock Value	$1,200	$1,000	$200

You might wonder which set of numbers is correct. The truth is that both are entirely valid accounting approaches. They simply represent different ways of looking at the same physical reality.

In an environment where supplier prices are rising, the first-in, first-out approach pairs your oldest and cheapest costs against your current revenue. This results in a lower cost of goods sold and a higher reported profit. It also leaves your remaining inventory valued at the most recent, higher prices. This closely matches current market replacement costs on your balance sheet.

The weighted average approach smooths out price fluctuations. It absorbs the shock of sudden supplier price hikes by spreading the increased costs across all your existing stock. This results in a higher cost of goods sold and a lower reported profit.

Crucially, neither method changes the amount of cash moving through your business. The $3,000 revenue remains the same, and the $2,500 you paid to your supplier remains the same. You will see no difference on your cash flow statement. The difference lies entirely in how and when you recognise those costs on your profit and loss reports.

Matching the method to your business type

Because both methods are valid, the right choice depends on the nature of your business and your physical goods.

The first-in, first-out approach is generally suited for businesses where goods have a shelf life or go out of date quickly.

• Supermarkets and grocers must sell older food items before they spoil.
• Fashion retailers need to clear out older seasonal clothing before trends change.
• Electronics shops want to sell older models before new versions make them obsolete.

For these businesses, this accounting method perfectly mirrors the physical reality of their warehouse operations.

The weighted average method is better suited for businesses that sell high volumes of identical items mixed together. In these environments, it is impossible or unnecessary to track specific batches.

• Hardware stores selling loose nails or screws out of a bin.
• Fuel stations pumping petrol from a single underground tank.
• Manufacturers buying raw materials like lumber, resin, or metal piping in bulk.

If your physical stock naturally mixes together and every unit is identical to the next, averaging the costs provides a highly accurate reflection of your business operations.

The danger of changing methods mid-year

Once you select a costing method, you must stick with it. Consistency matters far more than the initial choice itself.

If you change your costing method in the middle of a financial year, you completely distort your financial comparisons. Imagine looking at a profit and loss statement where January and February profits were calculated using first-in, first-out, but March and April profits were calculated using weighted average.

If your profit drops in April, you will not know why. Did your sales team offer too many discounts? Did your supplier raise prices? Or did the accounting change simply shift more costs into that month? You lose the ability to analyse your business performance accurately.

Tax authorities also require consistency. You generally cannot switch methods back and forth to manipulate your reported profit and lower your tax bill. If you decide that a change is genuinely necessary, you usually have to wait until the start of a new financial year and apply the new method consistently from that point forward. Consult your local tax authority or a qualified accountant before making such a change.

What to do next

Choosing how to value your stock is a foundational decision for your business. Take a walk through your warehouse and look at how your goods physically move. If you constantly push older stock to the front of the shelves, first-in, first-out is likely your best choice. If you pour new inventory into bins with old inventory, weighted average makes more sense.

Once you have made your decision, configure your accounting software to handle the math for you. Paper & Pen includes built-in inventory management that updates your stock values automatically as you record purchases and sales. You can set up your items, choose your preferred costing method, and let the system track your costs in the background. Create a free account today to start organising your stock and generating clear financial reports.