How are inventory issues and closing inventory valued using FIFO and AVCO, and what effect does the method have on profit?
Valuation of inventory issues and closing inventory using the first in first out (FIFO) and weighted average cost (AVCO) methods, and the effect of the chosen method on the cost of issues, closing inventory value and reported profit.
A focused answer to the SQA Higher Accounting inventory valuation content, covering the FIFO and AVCO methods for pricing inventory issues and closing inventory, working a stores ledger, and the effect of the method on profit when prices change.
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What this dot point is asking
The SQA wants you to value the inventory a business issues to production or sale, and the inventory left at the year end, using two recognised methods: first in first out (FIFO) and weighted average cost (AVCO). You must work a stores ledger and explain how the choice of method affects cost of sales, closing inventory and reported profit when prices change.
Why a method is needed
A store may hold units bought at several different prices. When some are issued, the business must decide which cost to charge, because the units themselves are identical and cannot be told apart. The valuation method is the agreed rule for answering that question. It matters because the cost charged on issue becomes part of cost of sales, and the value left becomes closing inventory, so the method directly affects profit.
FIFO
Under FIFO, issues are made from the oldest batch until it is exhausted, then from the next. Closing inventory is therefore valued at the most recent purchase prices. FIFO follows the physical flow of many real stores, where older stock is used first to avoid deterioration.
AVCO
Under AVCO, a new weighted average cost is calculated each time stock is received, and every issue is priced at the current average.
Effect on profit
The two methods value the same stock differently when prices change. In a period of rising prices, FIFO charges the cheaper old costs to cost of sales, giving a lower cost of sales and a higher profit, and leaves the dearer recent costs in closing inventory, giving a higher inventory value. AVCO averages the prices, so its profit and inventory value sit between FIFO and a pure oldest-cost approach. Neither method is more correct; the business must choose one and apply it consistently so results stay comparable.
When prices are falling, the effects reverse: FIFO now charges the dearer old costs first, giving a higher cost of sales and a lower profit, and leaves the cheaper recent costs in closing inventory, giving a lower inventory value. AVCO again sits between the extremes. The consistency concept is the reason a business cannot switch method from year to year to flatter its profit, because that would make one year's results incomparable with the next. The prudence concept also applies on top of either method: if the net realisable value of the inventory has fallen below its cost, the inventory must still be written down to that lower figure regardless of whether FIFO or AVCO produced the cost.
Try this
Q1. Buy 50 units at £10 then 50 at £14, and issue 60 units. Calculate the FIFO cost of the issue. [2 marks]
- Cue. (50 x £10) + (10 x £14) = £500 + £140 = £640.
Q2. Using the same purchases, calculate the AVCO cost per unit before the issue. [2 marks]
- Cue. (£500 + £700) / 100 = £1,200 / 100 = £12 per unit.
Q3. State which method gives the higher closing inventory value when prices are falling. [1 mark]
- Cue. AVCO, because FIFO would value the remaining units at the newest, lower prices.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher style5 marksA business buys 100 units at £4 then 100 units at £6, and later issues 150 units. Using FIFO, calculate the cost of the issue and the value of the 50 units remaining.Show worked answer →
Under FIFO the earliest purchases are issued first. The 150 units issued are the first 100 (at £4) plus 50 of the next batch (at £6) (1 mark).
Cost of issue = (100 x £4) + (50 x £6) = £400 + £300 = £700 (2 marks).
The 50 units remaining are from the £6 batch, valued at 50 x £6 = £300 (2 marks). Markers reward the correct order of issue, the cost of the issue and the closing value.
SQA Higher style4 marksExplain why FIFO and AVCO can produce different profit figures when prices are rising, and state which method gives the higher closing inventory value in that case.Show worked answer →
When prices rise, FIFO issues the older, cheaper units first, so the cost of sales is lower and the profit is higher (1 mark), and the closing inventory is valued at the most recent, higher prices (1 mark).
AVCO smooths the price by averaging, so its cost of sales sits between the FIFO and an older-cost figure, giving a profit between the two (1 mark).
In a period of rising prices FIFO gives the higher closing inventory value, because the units left are priced at the latest, higher costs (1 mark). Markers reward the effect on cost of sales and profit and the correct identification of FIFO.
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Sources & how we know this
- SQA Higher Accounting Course Specification — SQA (2023)