FIFO vs Weighted Average Cost: Which Method a Manufacturer Should Choose

FIFO writes material off at the price of the earliest batches, while weighted average cost uses the average price of all stock in the warehouse. When purchase prices rise, FIFO gives a lower write-off cost and a higher profit; when they fall, the reverse. Bimp is a Ukrainian cloud ERP for manufacturers, and it applies FIFO when batch accounting is on and weighted average cost when batch accounting is off.

A furniture shop’s production engineer buys plywood three times in a quarter: in January at €20 a sheet, in February at €23, in March at €26. In April the shop takes 150 sheets from the warehouse. At what price should they go into the cost of the order? The answer decides how much profit the April report shows.

How does FIFO differ from weighted average cost?

Under FIFO (“first in, first out”) material is written off from the oldest batch, and when it runs out, from the next one. The warehouse keeps the price of each batch separately, so every write-off carries a specific set of prices. The stock left in the warehouse is valued at the prices of the newest receipts.

Weighted average works with one price for the whole balance. The formula is:

Average price = value of all stock / quantity of all stock

Every new receipt changes the average price, and write-offs go at that price, no matter which batch the material was physically taken from. In this kind of accounting the batches merge into one total.

How do you calculate cost with both methods on an example?

Say the shop’s warehouse holds three batches of plywood. All three arrived before the first write-off. The company is hypothetical.

The average price is 6,900 / 300 = €23 a sheet.

In April the shop writes off 150 sheets to production. In May another 100. There are no new receipts between these two write-offs.

Write-off 1, 150 sheets. Under FIFO we take the whole January batch and half of February’s: 100 × 20 + 50 × 23 = 2,000 + 1,150 = €3,150. Under weighted average we take 150 × 23 = €3,450. The difference is €300.

Write-off 2, 100 sheets. Under FIFO, 50 sheets remain in the February batch and the rest comes from March: 50 × 23 + 50 × 26 = 1,150 + 1,300 = €2,450. Under weighted average the price stays at €23, because there were no new receipts: 100 × 23 = €2,300.

Both methods distribute the same €6,900. The only difference is which part has reached cost and which part has stayed in the warehouse. FIFO left 50 sheets at €26 in the warehouse, which is €1,300, and weighted average left 50 sheets at €23, which is €1,150. That €150 is the difference between the total write-offs, 5,750 - 5,600 = €150.

How does the method affect product cost and profit?

Suppose each product uses 2 sheets of plywood, so 150 sheets made 75 products, and dealers bought them at €100 each. Revenue is 75 × 100 = €7,500.

Check: 4,350 / 7,500 = 0.58 and 4,050 / 7,500 = 0.54. The table counts only plywood. The rest of the cost (labour, shop overheads) is the same under both methods. The 4 percentage point difference appeared only because of the choice of method, since physically the shop used the same material.

The conclusion from the example is this. When prices rise, FIFO shows a higher profit, but the warehouse is valued higher, closer to market value. Weighted average smooths the jumps: product cost changes gradually and does not depend on which batch the storekeeper picked. When prices fall, the effect is reversed.

What happens if a new batch arrives before the second write-off?

This is where the methods diverge most. Suppose that in May, before the second write-off, another 100 sheets arrived at €28, worth €2,800.

Weighted average reacts at once. After the first write-off 150 sheets worth €3,450 remained, and with the new batch there are 250 sheets worth 3,450 + 2,800 = €6,250. The average price is 6,250 / 250 = €25, and writing off 100 sheets costs €2,500.

FIFO does not touch the new batch until the old ones run out. Writing off 100 sheets still takes 50 at €23 and 50 at €26, that is €2,450. The more expensive batch at €28 waits in the queue.

Check under FIFO: the warehouse holds 50 at €26 and 100 at €28, 1,300 + 2,800 = €4,100. Under weighted average: 150 × 25 = €3,750. So FIFO lags behind the market in the cost of write-offs, while it holds the warehouse at fresher prices. The average keeps up with the market in cost, but blurs the difference between batches.

Which mistakes do people make when choosing a method?

• They compare profit for different periods under different methods. If January was calculated on the average and February on FIFO, the method explains part of the margin change, and the market explains only the rest.
• They forget about stock. The method changes the cost of goods sold and the valuation of the warehouse on the balance sheet. The €150 difference in the example sits exactly there.
• They turn on batch accounting for FIFO but work without batches. If the storekeeper does not specify the batch in documents, batch accounting causes confusion, and the accountant has to fix the linking by hand.

Which cost method should a manufacturer choose?

Some guidelines:

• Choose FIFO when batches differ noticeably in price, the material has a shelf life and the owner wants to see the profitability of each delivery. Batch accounting is also needed if every batch must be traced to the warehouse, for example for certificates.
• Choose weighted average when the material is uniform and arrives often: rolled metal, fabric from one roll, bulk goods. Separate batches do not differ in quality here, and the price moves within a few percent.
• Accounting policy. The method is fixed in the company’s accounting policy. IFRS (IAS 2) allows both FIFO and weighted average, so this is the company’s choice, and national rules may differ. Agree the final decision with your accountant and do not change the method in the middle of a reporting period without need.

For a small shop with a dozen materials, weighted average is usually enough. When purchasing is more complex and prices differ between suppliers, FIFO gives a more precise picture of each delivery. What cost is made of is covered in the article on how to calculate manufacturing cost.

How do you switch the method in Bimp?

The method depends on one switch. Open “Company settings”, then the “Accounting settings” tab, and find “Keep goods records by batches”. When the switch is on, Bimp creates a card for each batch and writes off by FIFO. When it is off, there are no batches in the system, and cost is calculated as the average price of the stock.

Bimp has no separate choice between methods such as “FIFO / average / LIFO”: the method follows from whether you keep records by batches. Whether the system recalculates documents that are already posted after the switch, ask support before changing the setting.

Extra costs for delivery or customs duty raise the value of a batch or of the balance regardless of the method. How they get into the price is explained in the article on freight, customs and delivery in the cost of imported components.

What Bimp does and does not do

Bimp writes off cost by FIFO if “Keep goods records by batches” is on, and at the weighted average cost of all stock if batch accounting is off. The cost of goods consists of the purchase price and additional costs, and for finished products it includes materials under the specification and labour. The result is visible in the Gross profit report, and for unfinished orders there is Accumulated cost. More on how cost is formed and on the methods is in the article Cost price methods, and on the batch, serial and VAT switches in Accounting settings.

The limits are these. Bimp has no separate switch for other methods, such as LIFO or specific identification. The choice between FIFO and the average comes down to batch accounting. The accounting policy and the tax consequences of the method are decided by the accountant, and the system only calculates in the chosen mode.

To see how a product’s cost is built from materials, labour and overheads, visit the Bimp site.

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