Ramesh sells about 130 SKUs in his 600 sq ft kirana. Atta is his biggest seller. In March, he bought 50kg @ ₹38. April: 70kg @ ₹42 (post a wheat price hike). May: 50kg @ ₹45. He sold 130kg through the quarter at retail ₹56/kg.
His CA asks at GST audit: "What inventory method are you using? FIFO or weighted average?"
Ramesh: "What's that?"
Five minutes of explanation later, he realises that the answer changes his profit by ₹360 on atta alone — and across 130 SKUs, it can add up to a meaningful tax difference.
- Two acceptable methods in India: FIFO (First-In-First-Out — oldest stock cost is used for sales) and Weighted Average (running average cost per unit).
- LIFO is NOT allowed under ICDS-II (Income Computation and Disclosure Standards) for tax purposes. Allowed under some old accounting conventions but withdrawn under Ind AS / ICDS.
- In a rising-price environment: FIFO gives lower COGS → higher profit → higher tax. Weighted Average smooths the impact.
- In a falling-price environment: reverse — FIFO higher COGS → lower profit.
- Consistency principle: once you pick a method, you must stick with it. Switching between FIFO and Weighted Average requires disclosure in financial statements and a reasonable justification. Tax authorities scrutinise method changes that conveniently reduce tax.
The math on Ramesh's atta
Stock movements for Q1 (Mar-May):
- Mar 1: buy 50kg @ ₹38 = ₹1,900
- Apr 5: buy 70kg @ ₹42 = ₹2,940
- May 10: buy 50kg @ ₹45 = ₹2,250
- Total purchases: 170kg, ₹7,090.
- Sold over the quarter: 130kg at retail ₹56/kg = ₹7,280 revenue.
- Closing stock: 40kg.
FIFO
First-bought sold first
Sells the 50kg March stock first (₹38), then 70kg April (₹42), then 10kg May (₹45). COGS = 50×38 + 70×42 + 10×45 = ₹5,290. Closing 40kg May @ ₹45 = ₹1,800. Gross profit = 7,280 − 5,290 = ₹1,990.
Weighted Average
Running average cost
Total available 170kg @ ₹7,090 → weighted avg ₹41.71/kg. COGS = 130 × 41.71 = ₹5,423. Closing 40 × 41.71 = ₹1,668. Gross profit = 7,280 − 5,423 = ₹1,857.
Differential profit between FIFO and WA on atta alone: ₹133 (in this quarter). Annualised + applied across 130 SKUs in a rising-price economy, the differential can reach ₹15-40k of taxable profit. At 30% slab, that's ₹4-12k of annual tax. Not big for a kirana — but materially relevant for a wholesale distributor or a manufacturer with thousands of SKUs.
ICDS-II — the tax rulebook
The Income Tax Department issued Income Computation and Disclosure Standards (ICDS) in 2017, applicable to all assessees other than individuals / HUFs not covered by tax audit. ICDS-II deals with inventory valuation:
- Inventory should be valued at cost OR net realisable value (NRV), whichever is lower.
- Cost can be determined using FIFO or Weighted Average — your choice.
- LIFO is explicitly NOT permitted.
- Specific identification permitted only for non-fungible items (jewellery, custom-built items).
- The chosen method must be applied consistently across years.
- Change of method requires disclosure + reasonable cause. AO can challenge if the change has tax-reduction intent.
Ind AS 2 (the corresponding accounting standard) is aligned with ICDS-II — same two-method choice, same LIFO prohibition.
Which method to pick
Pick FIFO if
Physical-flow match
Perishables (food, dairy, pharma). Date-coded inventory (expiry-based). Single-source supply where each batch is identifiable. Closing stock value should reflect recent purchase prices — balance-sheet realism.
Pick Weighted Average if
Bulk fungibles
Bulk fungible items (steel, chemicals, cement, grains). Stock often mixed in silos / tanks. Frequent purchases at small price variations. P&L should reflect smoothed cost — earnings consistency.
Specific identification
Non-fungibles
Jewellery (each piece unique). Real-estate inventory (each unit). High-value custom equipment. Maintain serial-number / lot-number identification. ICDS-II permits this for non-fungibles.
For Ramesh's kirana: FIFO is the natural choice. Atta has shelf-life; he physically sells older stock first to avoid expiry losses. Method matches actual flow.
For a steel distributor: Weighted Average is typical. Steel rods are commingled; specific batch identification isn't practical. Smoothed cost makes more sense.
What the auditor actually checks
- Disclosure: financial statements must state the method used. Schedule III (Companies Act) + Ind AS 2 require disclosure of inventory accounting policies.
- Consistency: method same as prior year. Any change explained with reason.
- Physical inventory: year-end physical count reconciled with system stock. Variance > 2-3% triggers detailed review.
- NRV test: items where market price has dropped below cost → write down to NRV. Slow-moving / obsolete / damaged inventory provisioned for.
- GST cross-check: GSTR-1 outward supplies value should correlate with sales × inventory turnover. GSTR-2B inward should correlate with purchases.
The funny historical wrinkle
India's withdrawal of LIFO predates ICDS — Ind AS 2 (2016) prohibited it. The rationale: LIFO produces unrealistic closing stock values (decades-old prices remain on balance sheet) and is easily manipulated in inflationary periods to reduce tax. Most major economies have moved away from LIFO; the US is one notable holdout (US GAAP still permits LIFO for tax purposes, leading to "LIFO reserve" disclosures on US companies' balance sheets). India aligned with global practice.
The practical effect: in a rising-price economy, Indian businesses report slightly higher profits (and tax) than they would have under LIFO. The trade-off is more accurate balance-sheet values and reduced manipulation risk.
Quick answers
No mid-year switches. Year-on-year change is permitted with disclosure + justification. Tax auditor will scrutinise if change appears tax-motivated.
Disclose the change in the year of transition. Restate prior-year comparatives in financial statements (Ind AS 8 retrospective application). Tax adjustment for the year-of-change differential needs to be disclosed.
Less, in absolute terms. High turnover (e.g., 12+ times/year) means closing stock represents only days of purchases — FIFO vs WA differential narrows. Slow turnover (e.g., 2 times/year) means closing stock has lots of old purchase prices — bigger differential.
When market price has dropped below your purchase cost. Example: bought a SKU at ₹100; current selling price is ₹85; cost less than NRV requires writing down to ₹85. Often comes up in fashion / electronics / commodity-linked inventory.
Standard costing can be used for internal management but must reconcile to actual cost (FIFO or WA) for financial reporting. The variance gets adjusted to inventory or COGS depending on cause.
When you might want help
Two situations: (1) Inventory-heavy business reviewing method choice — FIFO vs WA + ERP configuration + audit defence. (2) Method change in the works — Ind AS 8 disclosure + restatement + AO communication.
Inventory method confused?
Method selection, ERP configuration, NRV adjustment, audit-grade documentation. Fixed-scope review.
"Ramesh" and the atta prices are composite illustrations. Method choice depends on actual inventory turnover, type, and audit considerations.