Under ICAI's AS 2 (and Ind AS 2), inventory is valued at the lower of cost and net realisable value. For interchangeable goods, cost is assigned using FIFO or weighted average; specific identification is required for items that are not interchangeable or are made for specific projects. LIFO is not one of the permitted formulas. Standard cost and retail methods are allowed only if results approximate actual cost.
Stock valuation is the method you use to put a rupee value on the goods left unsold at the end of a period. That number does double duty: it is an asset on your balance sheet and it decides your cost of goods sold, and therefore your profit. In India the rules come from ICAI's Accounting Standard (AS) 2 and, for companies under Ind AS, Ind AS 2. This guide explains the permitted methods with worked numbers.
Why does the stock valuation method matter?
Profit depends directly on closing stock:
Cost of goods sold (COGS) = Opening stock + Purchases − Closing stock
Overvalue closing stock by ₹50,000 and you overstate profit by ₹50,000 — and the tax on it. Undervalue it and you understate profit this year, which reverses next year when that stock becomes opening stock. Lenders also look at stock value when they set working-capital limits, so a consistent, defensible method matters well beyond the tax return.
What is the basic rule under AS 2?
AS 2 states that inventories should be valued at the lower of cost and net realisable value (NRV).
- Cost includes the costs of purchase, costs of conversion and other costs incurred to bring the inventories to their present location and condition.
- NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.
What goes into cost?
The costs of purchase consist of the purchase price, including duties and taxes other than those subsequently recoverable from the taxing authorities, plus freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates and duty drawbacks are deducted.
AS 2 excludes from cost, among other things:
- abnormal amounts of wasted materials, labour or other production costs,
- storage costs, unless necessary in the production process before a further stage,
- administrative overheads that do not help bring inventories to their present location and condition, and
- selling and distribution costs.
| Item | Include in stock cost? |
|---|---|
| Invoice price of goods | Yes |
| GST claimed as input tax credit | No |
| Inward freight and loading | Yes |
| Trade discount on the invoice | Deduct |
| Godown rent for finished goods | Generally no |
| Showroom salaries, advertising | No |
| Abnormal wastage in production | No |
What cost formulas are permitted?
AS 2 gives three approaches, depending on the nature of the goods.
1. Specific identification
For items that are not ordinarily interchangeable, or goods produced and segregated for specific projects, cost must be assigned by specific identification of their individual costs. Think of a car dealer's vehicles (each with a chassis number), custom-made furniture, or a jeweller's individual pieces. AS 2 adds that specific identification is inappropriate for large numbers of interchangeable items, because the business could then pick which units "remain" to manage profit.
2. FIFO (first-in, first-out)
FIFO assumes that the items purchased or produced first are sold first, so closing stock consists of the most recent purchases.
3. Weighted average cost
The cost of each item is the weighted average of the cost of similar items at the beginning of the period and those purchased during the period. The average may be calculated periodically or as each additional shipment is received (moving average).
AS 2 says the formula chosen should reflect the fairest possible approximation to the cost incurred in bringing the items to their present location and condition.
What about LIFO?
LIFO (last-in, first-out) is not one of the permitted formulas. AS 2 names only FIFO and weighted average for interchangeable items, and ICAI's Ind AS 2 study material states LIFO is not permitted under Ind AS 2.
Convenience techniques: standard cost and retail method
AS 2 allows the standard cost method or retail method for convenience if the results approximate actual cost. The retail method is common in retail for large numbers of rapidly changing items with similar margins: cost is found by reducing the sales value of the inventory by the appropriate percentage gross margin.
Worked example: FIFO vs weighted average
A Surat textile trader deals in one fabric (all figures exclude GST, which is claimed as credit):
| Date | Transaction | Metres | Rate (₹) | Amount (₹) |
|---|---|---|---|---|
| 1 Apr | Opening stock | 500 | 200 | 1,00,000 |
| 10 May | Purchase | 1,000 | 220 | 2,20,000 |
| 20 Aug | Purchase | 1,500 | 240 | 3,60,000 |
| Available | 3,000 | 6,80,000 | ||
| Year | Sales | 2,200 | ||
| 31 Mar | Closing stock | 800 | ? |
FIFO
The 2,200 metres sold are taken from the oldest layers first: 500 at ₹200, 1,000 at ₹220, and 700 at ₹240. The 800 metres left are from the 20 August purchase at ₹240.
- Closing stock = 800 × ₹240 = ₹1,92,000
- COGS = ₹6,80,000 − ₹1,92,000 = ₹4,88,000
Weighted average (periodic)
Average cost = ₹6,80,000 ÷ 3,000 = ₹226.67 per metre.
- Closing stock = 800 × ₹226.67 ≈ ₹1,81,333
- COGS = ₹6,80,000 − ₹1,81,333 = ₹4,98,667
If sales were 2,200 metres at ₹300 = ₹6,60,000:
| FIFO | Weighted average | |
|---|---|---|
| Sales | ₹6,60,000 | ₹6,60,000 |
| COGS | ₹4,88,000 | ₹4,98,667 |
| Gross profit | ₹1,72,000 | ₹1,61,333 |
When prices are rising, FIFO shows a higher closing stock and higher profit; weighted average smooths the effect. Over the life of the business the total profit is the same — the method only shifts it between years. That is why consistency matters more than which method you prefer.
How do you apply the NRV test?
After calculating cost, compare it with NRV, usually item by item. AS 2 notes cost may not be recoverable if goods are damaged, obsolete, or their selling prices have fallen, or if costs to complete or sell have risen.
Worked example: NRV write-down
Continuing the textile case, 200 of the 800 metres are a faded colour. They will sell only at ₹210 per metre, with ₹15 per metre in sales commission.
- NRV of faded stock = ₹210 − ₹15 = ₹195 per metre
- FIFO cost = ₹240 per metre
- Value at lower = ₹195 → write-down = 200 × (₹240 − ₹195) = ₹9,000
Revised FIFO closing stock = ₹1,92,000 − ₹9,000 = ₹1,83,000.
AS 2 also says materials held for use in production are not written down below cost if the finished goods they go into are expected to sell at or above cost.
For perishable stock, near-expiry checks feed this test directly; see batch and expiry tracking.
How do you choose a method for your business?
| Business | Typical choice | Reason |
|---|---|---|
| Kirana / FMCG retail | Weighted average or retail method | Many SKUs, frequent purchases |
| Pharmacy / food | FIFO | Matches physical flow of perishables |
| Hardware, building material | Weighted average | Prices fluctuate, goods identical |
| Jewellery (unique pieces) | Specific identification | Items not interchangeable |
| Vehicle or machine dealer | Specific identification | Each unit has its own serial/chassis |
| Small manufacturer | FIFO or weighted average, plus conversion cost | Raw material and WIP |
Steps to put a method in place:
- Group items that are interchangeable versus unique.
- Pick a formula (FIFO or weighted average) for interchangeable groups and apply it consistently.
- Set up your item master so purchase costs exclude recoverable GST and include inward freight.
- Record every receipt and issue with quantity and rate; see inventory management basics.
- At period end, count stock, value it with the formula, then test each item against NRV.
- Disclose the policy. AS 2 requires disclosure of the accounting policies adopted in measuring inventories, including the cost formula used.
How does the valuation method affect your profit and loss?
Closing stock flows straight into your trading account, so every rupee of valuation difference is a rupee of gross profit difference. To see how COGS and gross profit sit in the statement, read profit and loss statement, and to understand why gross profit percentages differ from markup, see gross margin vs markup.
Inventory software that records each purchase at its actual net cost can produce FIFO or average-cost stock reports automatically. Billing Software by Betterwork's inventory and reports keep stock quantities in sync with invoices, which removes most of the manual work behind the valuation; the choice of method and the NRV judgment remain yours and your accountant's.
How does a perpetual (moving) weighted average work?
Billing software usually recalculates the average after every purchase instead of once at period end. Take one item:
| Step | Quantity | Rate | Value | Average after |
|---|---|---|---|---|
| Opening stock | 100 | ₹50 | ₹5,000 | ₹50.00 |
| Purchase | 100 | ₹60 | ₹6,000 | ₹55.00 (₹11,000 ÷ 200) |
| Sale | −120 | ₹55 | −₹6,600 | ₹55.00 (80 left = ₹4,400) |
| Purchase | 120 | ₹65 | ₹7,800 | ₹61.00 (₹12,200 ÷ 200) |
Sales never change the average; only purchases do. Two practical consequences follow. First, a purchase entered late, after sales were billed, changes the cost of those later sales, so enter purchase bills promptly. Second, purchase returns and supplier discounts should be posted against the original purchase so the average is corrected rather than distorted. The periodic method gives a single year-end average; the moving method gives a cost for every sale, which is what makes item-wise margin reports possible.
Common mistakes
- Including input tax credit in stock cost, which inflates closing stock and profit.
- Using LIFO or a "last purchase price" for all stock, which is not a permitted formula.
- Valuing at selling price or MRP instead of cost.
- Skipping the NRV test on damaged, obsolete or near-expiry stock.
- Switching methods year to year to smooth profit.
- Writing down in one lump instead of item by item.
- Leaving out inward freight, understating cost.
Key takeaways
- Value inventory at the lower of cost and net realisable value (AS 2 / Ind AS 2).
- Use FIFO or weighted average for interchangeable goods; specific identification for unique items.
- LIFO is not permitted.
- Exclude recoverable GST; include inward freight; deduct trade discounts.
- Test NRV item by item and write down where needed.
- Pick a method, apply it consistently and disclose it.
This guide is general information, not tax advice. Rules last checked on 20 October 2026; confirm with your tax professional for your situation.