A wholesaler buys 100 cartons of tea in March at one price and another 100 in April at a higher price. In May he sells 150 cartons. What did those 150 cartons cost him? The answer decides his profit for the month and the value of the stock left on the shelf. There is more than one correct way to answer, and the two most common are FIFO and average cost.
The two methods in one line each
- [FIFO](/glossary/fifo), first in first out: the oldest stock is assumed to be sold first, so sales are costed at the oldest purchase prices.
- [Weighted average cost](/glossary/weighted-average-cost): all units of an item share one average cost, recalculated when new stock comes in.
Neither method needs to match which carton physically left the godown. They are accounting rules for assigning cost. What matters is choosing one and applying it consistently.
Worked example: prices going up
A Lahore distributor buys a product in two lots and then sells 150 units at Rs 700 each:
| Event | Units | Price (Rs) | Amount (Rs) |
|---|---|---|---|
| Purchase lot 1 | 100 | 500 | 50,000 |
| Purchase lot 2 | 100 | 560 | 56,000 |
| Total available | 200 | 106,000 | |
| Sale | 150 | 700 | 105,000 |
Under FIFO
The 150 units sold are costed as all 100 units from lot 1 plus 50 units from lot 2. Cost of goods sold = 100 x 500 + 50 x 560 = 50,000 + 28,000 = Rs 78,000. The 50 units left are valued at the newest price: 50 x 560 = Rs 28,000. Gross profit = 105,000 - 78,000 = Rs 27,000.
Under weighted average
Average cost = 106,000 / 200 = Rs 530 per unit. Cost of goods sold = 150 x 530 = Rs 79,500. Closing stock = 50 x 530 = Rs 26,500. Gross profit = 105,000 - 79,500 = Rs 25,500.
| FIFO (Rs) | Weighted average (Rs) | |
|---|---|---|
| Sales | 105,000 | 105,000 |
| Cost of goods sold | 78,000 | 79,500 |
| Gross profit | 27,000 | 25,500 |
| Closing stock value | 28,000 | 26,500 |
| COGS + closing stock | 106,000 | 106,000 |
Notice the last row. Both methods split the same Rs 106,000 of purchases between cost of goods sold and closing stock. They only differ in how much falls on each side this month. Over the full life of the stock, total profit is the same.
What happens when prices fall
Reverse the lots: lot 1 is 100 units at Rs 560 and lot 2 is 100 units at Rs 500. FIFO now costs the sale at 100 x 560 + 50 x 500 = 56,000 + 25,000 = Rs 81,000, giving a gross profit of Rs 24,000. The average is still Rs 530, so average cost still gives Rs 79,500 and Rs 25,500. With falling prices, FIFO shows the lower profit.
The rule of thumb: when prices are rising, FIFO shows higher profit and higher stock value; when prices are falling, it shows lower profit. Average cost smooths out the swings either way.
Moving average in daily trading
In a real shop, purchases and sales are mixed together. A moving average recalculates the average after each purchase. Example:
- Opening: 100 units at Rs 500 = Rs 50,000.
- Sell 60 units. Cost = 60 x 500 = Rs 30,000. Left: 40 units worth Rs 20,000.
- Buy 60 units at Rs 560 = Rs 33,600. Now 100 units worth 20,000 + 33,600 = Rs 53,600, so the new average is Rs 536.
- Sell 50 units. Cost = 50 x 536 = Rs 26,800. Left: 50 units worth Rs 26,800.
Doing this by hand for hundreds of items is not realistic. It is exactly the kind of calculation software should do every time you record a purchase or a sale.
Which one suits your business?
| Business type | Usually suits | Why |
|---|---|---|
| Pharmacy, food, cosmetics | FIFO with batch tracking | Older stock must leave first to avoid expiry |
| Hardware, building materials | Weighted average | Identical items, frequent price changes, no expiry |
| Grocery and kiryana wholesale | Either; average is simpler | High volume, small margins, many purchases |
| Electronics and mobiles | FIFO or specific item cost | Prices drop over time; serial numbers matter |
For goods with expiry dates, physical rotation matters as much as the costing rule. Batch and expiry tracking lets a pharmacy sell the batch that expires first, whatever costing method the accounts use. In Taajir, batches with expiry dates and first-expired-first-out (FEFO) picking come with the Manufacturing add-on, and IMEI or serial numbers come with the Lots & Serials add-on; see batch and expiry tracking and IMEI and serial tracking.
How the method affects your pricing decisions
Costing methods are not only an accounting matter. They change the number your salesman sees when he decides how much discount he can give. Take the rising-price example. Under FIFO, the system says the next 50 units cost Rs 560. Under weighted average, it says Rs 530. If a customer asks for a discount on 50 units at Rs 700, a salesman looking at the average may think he has Rs 170 a unit to play with, when replacing that stock will actually cost Rs 560 or more.
Whatever method your books use, keep an eye on the latest purchase price when setting selling prices. When a supplier raises his rate from Rs 560 to Rs 600, your selling price should move promptly, even if your average cost is still catching up. Many traders lose margin for weeks after a price rise simply because they priced from the old cost.
Returns and adjustments
When a customer returns goods, put them back into stock at the cost they went out at, so cost of goods sold falls by the same amount. When you return goods to a supplier, remove them at the price you paid for that lot. Stock written off as damaged should leave at its recorded cost and show up as a loss, so you can see how much breakage and expiry really cost each month.
Consistency is the real rule
Switching methods from month to month makes your profit figures meaningless, because you can no longer compare one month with the next. Pick a method with your accountant, use it for all items of a type, and change only for a good reason with a clear note of when and why. Also ask your accountant which method is acceptable for your tax filings.
Common mistakes
- Using the latest purchase price for all stock, which is neither FIFO nor average and overstates stock when prices rise.
- Valuing stock at selling price, which counts profit before the sale happens.
- Ignoring freight and loading. The true cost of stock is its landed cost, including transport to your godown.
- Forgetting returns to suppliers, which should reduce stock at the cost they came in at.
The method you choose flows straight into your stock valuation and your gross profit. An inventory system such as Taajir records each purchase price as you enter the supplier bill, so these figures come from your actual transactions rather than from memory at the end of the year.