Why does the valuation method affect profit?
When you buy the same item in batches at different prices and then sell part of it, you have to decide: which cost do you assign to the units sold, and which cost remains in inventory? This decision determines cost of goods sold and the inventory balance in the statement of financial position, and therefore gross profit.
International Accounting Standard 2 “Inventories” (IAS 2), endorsed in the Kingdom by the Saudi Organization for Chartered and Professional Accountants (SOCPA), permits two methods for interchangeable, similar items: first in, first out (FIFO) and weighted average cost. Items that are not interchangeable, such as cars with chassis numbers or custom projects, are valued using specific identification of the cost of each unit.
The choice is not a technical detail: it affects reported profit, the inventory balance the bank sees, and comparisons between years. It must therefore be set out in the accounting policies and disclosed in the notes to the financial statements.
Example data
A motor oil distributor in Riyadh has the following movements for a single item during a month:
| Movement | Quantity (cartons) | Unit cost (SAR) | Total (SAR) |
|---|---|---|---|
| Opening balance | 100 | 40 | 4,000 |
| Purchase 1 | 300 | 44 | 13,200 |
| Purchase 2 | 200 | 50 | 10,000 |
| Available for sale | 600 | 27,200 |
During the month it sold 450 cartons at 70 SAR per carton excluding VAT, i.e. sales of 31,500 SAR. 150 cartons remain.
Method one: first in, first out
It assumes the oldest units are sold first, so the most recent purchases remain in inventory. This usually matches the actual physical flow of goods.
- From the opening balance: 100 × 40 = 4,000 SAR
- From the first purchase: 300 × 44 = 13,200 SAR
- From the second purchase: 50 × 50 = 2,500 SAR
- Cost of goods sold = 19,700 SAR
- Closing inventory: 150 × 50 = 7,500 SAR
Method two: weighted average cost
It calculates the average cost per unit available for sale and applies it to both the units sold and the units remaining.
- Average cost = 27,200 ÷ 600 = approximately 45.33 SAR
- Cost of goods sold = 450 × 27,200 ÷ 600 = 20,400 SAR
- Closing inventory = 150 × 27,200 ÷ 600 = 6,800 SAR
This is the periodic weighted average, calculated once at the end of the period. In systems that record movements in real time, the moving average is used: the average is recalculated after each purchase, and the figures are close but not necessarily identical.
Comparison and how to choose
| Item (SAR) | FIFO | Weighted average cost |
|---|---|---|
| Sales | 31,500 | 31,500 |
| Cost of goods sold | 19,700 | 20,400 |
| Gross profit | 11,800 | 11,100 |
| Closing inventory | 7,500 | 6,800 |
In a period of rising prices, FIFO shows higher profit and an inventory value closer to current replacement prices, while the weighted average smooths the effect of price fluctuations. The total cost is the same in both cases (27,200 SAR); the only difference is how it is allocated between the current period and the next.
Note the effect on Zakat or income tax as well: higher profit and inventory balance under a given method change the figures on which the base is built. The chosen method must therefore be documented in the accounting policies and applied consistently, not chosen each year according to whichever result is most convenient.
For businesses that deal in foreign currencies or import their goods, remember that purchase cost includes the purchase price converted at the exchange rate on the transaction date, plus freight, insurance and non-recoverable customs duties. The average, or the FIFO layers, must be calculated on this full cost, not on the invoice price alone; otherwise profit will appear higher than it really is.
Important points when choosing
- Consistency: the same method must be used for items of a similar nature and use, and it must not be changed from year to year except for a reason that is disclosed.
- Nature of the goods: medicines and foods with expiry dates are physically issued by earliest expiry first, and FIFO is closer to this for valuation, although physical issuing and accounting valuation are separate decisions.
- Net realizable value: whatever the method, inventory is measured at the lower of cost and net realizable value. If an item's selling price falls or it is damaged, its balance is written down.