How can two businesses buy the same goods, sell the same quantity and report different gross profits? One explanation is how they assign cost to the units sold. The amount paid to the supplier does not change, but its allocation between cost of sales and remaining inventory can differ.
IAS 2 identifies first-in, first-out, or FIFO, and weighted average as cost formulas for interchangeable items. Specific identification applies to items that are not ordinarily interchangeable. To understand the effect, start with a small sequence that can be recalculated manually before looking at a report containing thousands of products.
Two purchases and one sale
In this educational example, a retailer buys 100 units for SAR 20 each, then another 100 for SAR 30 each. After both purchases it sells 120 units for SAR 40 each. There are no additional purchasing costs or returns, and the units are homogeneous. Goods available therefore total 200 units costing SAR 5,000, while sales revenue is SAR 4,800.
Under FIFO, the sale takes the cost of the first 100 units, SAR 2,000, plus 20 units from the second batch, SAR 600. Cost of sales is SAR 2,600. The remaining 80 units carry a cost of SAR 30 each, or SAR 2,400 in total.
Weighted average in this sequence is SAR 5,000 divided by 200, or SAR 25 per unit. The 120 units sold cost SAR 3,000, leaving inventory of SAR 2,000. Periodic and moving averages agree here because the sale followed both purchases, not because those approaches always produce identical results.
| Result | FIFO | Weighted average |
|---|---|---|
| Revenue | 4,800 | 4,800 |
| Cost of sales | 2,600 | 3,000 |
| Gross profit | 2,200 | 1,800 |
| Remaining inventory cost | 2,400 | 2,000 |
| Cost of sales plus inventory | 5,000 | 5,000 |
The SAR 400 difference in gross profit is matched by the same difference in remaining inventory. The formula has not generated extra cash or reduced the supplier liability. Comparing branches without understanding their policies and data could reward a manager for an accounting difference rather than superior trading performance.
What if the sale occurs between purchases?
Change only the sequence: buy 100 units at SAR 20, sell 60, then buy another 100 at SAR 30. Under moving average, those 60 units leave at a cost of SAR 1,200. The remaining 40 units cost SAR 800. Adding the new purchase of SAR 3,000 produces 140 units costing SAR 3,800, with an average of approximately SAR 27.142857.
The later purchase does not retrospectively enter the earlier sale's moving-average cost merely because the month is still open. A periodic average uses a different aggregation. The word “average” therefore needs a precise meaning in both the system configuration and the accounting policy. Preserve adequate calculation precision internally and round amounts under documented rules, rather than rounding unit costs prematurely and accumulating differences.
FIFO assigns costs; it does not prove that a warehouse operator physically picked the oldest item. Actual picking order, expiry dates and batch traceability also need operational controls.
Before accepting a profitability report, test two purchases, a sale and a return in a test environment, then change their date sequence. Ask how the return is costed and what happens when an older invoice is entered after the goods have been sold. This small exercise reveals more than a general statement that the software “supports average costing.”
Choosing a formula is not a competition to report the highest profit in a month of rising prices. Document the appropriate policy, review any proposed change with the relevant specialist before implementation, and retain the ability to reconstruct cost from movements. An explainable number makes it possible to separate purchase-price effects from discounts and sales mix, supporting pricing decisions grounded in actual economics.
Sources & further reading
Visit the original source to explore the concept and its wider context.
General educational content. Appropriate treatment depends on your business and accounting policies; consult your accounting professional when applying it to business records.
