ASCMS01 — Inventory Valuation: FIFO, AVCO & JIT

Understanding how inventory is valued using FIFO and AVCO, and how Just-in-Time inventory management affects costs, inventory levels and business decisions.

Learning Objectives

By the end of this supplementary topic, students should be able to:
    1. explain why inventory must be valued;
    2. explain the FIFO method;
    3. calculate inventory values using FIFO;
    4. explain the AVCO method;
    5. calculate inventory values using periodic AVCO;
    6. calculate inventory values using perpetual AVCO;
    7. distinguish between periodic and perpetual AVCO;
    8. explain the principles of Just-in-Time inventory management;
    9. identify advantages and disadvantages of JIT; and
    10. apply inventory valuation and JIT concepts to business situations.

Concept Framework

Why Is Inventory Valued?

Inventory is an important current asset for many businesses.

At the end of an accounting period, inventory must be assigned a value so that it can be included in the financial statements.

Inventory valuation affects:

  • closing inventory;
  • cost of sales;
  • gross profit; and
  • profit for the year.

Therefore, the method used to value inventory can affect reported financial results.

First In, First Out

 

FIFO assumes that the earliest units purchased are issued or sold first.

Therefore, the units remaining in closing inventory are assumed to come from the more recent purchases.

Example

A business has:

PurchaseUnitsCost per unit
Opening inventory100£5
Purchase 180£6
Purchase 2120£7

If 220 units are sold, 80 units remain.

Under FIFO, the closing inventory consists of the most recent units:

80 units × £7 = £560

Closing inventory = £560

Using the same information:

Total units available:

100 + 80 + 120 = 300 units

Units sold:

220 units

Under FIFO, the units sold are taken from the oldest inventory first.

Cost of units sold

 

100 units × £5 = £500

80 units × £6 = £480

40 units × £7 = £280

Cost of sales = £1,260

Closing inventory:

80 units × £7 = £560

Check:

£1,260 + £560 = £1,820

Total cost of inventory available:

£500 + £480 + £840 = £1,820

Average Cost Method

 

AVCO means Average Cost.

Instead of assigning different costs to individual batches of inventory, an average cost per unit is calculated.

The Cambridge syllabus requires students to understand both periodic and perpetual AVCO.

Under periodic AVCO, the average cost is calculated at the end of the accounting period.

Formula

Average Cost per Unit =

Total Cost of Units Available ÷ Total Units Available

Example

A business has:

100 units at £5 = £500

80 units at £6 = £480

120 units at £7 = £840

Total units:

300

Total cost:

£1,820

Average cost:

£1,820 ÷ 300 = £6.0667

Therefore, average cost per unit ≈ £6.07

If 80 units remain:

80 × £6.0667 ≈ £485.33

Closing inventory ≈ £485.33

Perpetual AVCO

 

Under perpetual AVCO, a new average cost is calculated whenever a new purchase is received.

The average cost therefore changes during the accounting period.

Basic process

 

Existing inventory value + New purchase value

÷

Existing units + New units

=

New average cost per unit

This new average cost is then used for subsequent issues until another purchase changes the average.

FeaturePeriodic AVCOPerpetual AVCO
Average calculatedAt the end of the periodAfter each purchase
Average costOne period-end averageChanges during the period
Issues during periodDo not immediately change averageUse current average
CalculationSimplerMore detailed

Students should carefully identify which method the question requires before beginning the calculation.

A business has:

Opening inventory

100 units at £5

Total = £500

Purchase

100 units at £7

Total = £700

New average cost:

(£500 + £700) ÷ (100 + 100)

= £1,200 ÷ 200

= £6 per unit

If 80 units are issued:

80 × £6 = £480

Remaining inventory:

200 − 80 = 120 units

Value:

120 × £6 = £720

The next purchase would require a new average cost to be calculated.

What Is JIT?

 

Just-in-Time inventory management aims to arrange for inventory to arrive close to the time it is needed for production or sale.

The objective is to reduce the amount of inventory held by the business.

JIT is therefore a management approach, not an inventory valuation method.

Lower Storage Costs

Less inventory may reduce warehousing and storage costs.

Lower Risk of Obsolescence

Holding less inventory may reduce the risk of goods becoming obsolete.

Less Capital Tied Up

Less money is tied up in inventory.

Reduced Inventory Levels

The business may operate with lower quantities of inventory.

Potentially Better Efficiency

Inventory may move through the business more quickly when purchasing and production are well coordinated.

Supply Problems

A delay from a supplier may interrupt production or sales.

Dependence on Suppliers

Reliable suppliers become particularly important.

Transport Problems

Delays can quickly affect the availability of inventory.

Limited Safety Stock

The business may have little spare inventory available when unexpected demand occurs.

Demand Changes

Unexpected increases in demand may create shortages.

JIT may be particularly suitable when:

  • suppliers are reliable;
  • deliveries can be made frequently;
  • demand can be forecast reasonably well;
  • inventory can be replenished quickly; and
  • storage costs are significant.

However, a business should consider the risks before adopting JIT.

A manufacturer currently holds £100,000 of inventory.

The business is considering JIT.

Possible benefits

Reducing inventory could:

  • reduce storage costs;
  • release cash;
  • reduce the risk of obsolete inventory; and
  • reduce the amount of capital tied up in stock.
Possible risks

The manufacturer may become more vulnerable to:

  • supplier delays;
  • transport disruption;
  • unexpected demand;
  • production interruptions.
Conclusion

JIT could provide financial and operational benefits, but its suitability depends on the reliability of suppliers, the nature of demand and the business’s ability to manage its supply chain.

Structured Practice

Level 1 — Knowledge
Question 1

What does FIFO stand for?

(1 mark)

Question 2

Explain the difference between periodic and perpetual AVCO.

(3 marks)

Question 3

State two principles of JIT inventory management.

(2 marks)

Question 4

A business has:

100 units at £4
150 units at £5
100 units at £6

The business sells 250 units.

Calculate the value of closing inventory using FIFO.

(4 marks)

Question 5

Using the same information, calculate the closing inventory using periodic AVCO.

(4 marks)

Question 6

A manufacturer is considering introducing JIT.

Explain two advantages and two disadvantages of the decision.

(8 marks)

📌 Additional inventory-valuation and JIT questions are available through the Question Papers + YouTube Explanation section.

Proficiency Check

Learn → Unlearn → Relearn

 

Learn
  1. Explain FIFO.
  2. Explain AVCO.
  3. Explain periodic AVCO.
  4. Explain perpetual AVCO.
  5. Explain JIT.
Unlearn
  1. Is JIT an inventory valuation method?
  2. Does FIFO always mean that the oldest physical goods are actually sold first?
  3. Is a higher inventory level automatically better for a business?
  4. Does JIT mean that a business should hold absolutely no inventory?
Relearn
  1. Explain why FIFO may result in closing inventory being valued using more recent purchase costs.
  2. Explain why perpetual AVCO can produce a different result from periodic AVCO.
  3. A business has unreliable suppliers but wants to reduce storage costs.

Explain why JIT may create both an opportunity and a risk.

Detailed Activity Solutions

Level 1
Question 1

FIFO = First In, First Out.

Question 2

Under periodic AVCO, the average cost is calculated at the end of the accounting period.

Under perpetual AVCO, a new average cost is calculated after each purchase.

Question 3

Possible principles include:

  • keeping inventory levels low;
  • receiving inventory close to when it is needed;
  • reducing storage requirements; and
  • coordinating closely with suppliers.
Question 4 — FIFO

Inventory available:

100 units × £4 = £400

150 units × £5 = £750

100 units × £6 = £600

Total = 350 units

Units sold = 250

Under FIFO, the 250 units sold are:

100 × £4 = £400

150 × £5 = £750

Cost of sales = £1,150

Remaining inventory:

100 units × £6 = £600

Closing inventory = £600

Question 5 — Periodic AVCO

Total cost:

£400 + £750 + £600 = £1,750

Total units:

350

Average cost:

£1,750 ÷ 350 = £5

Closing inventory:

100 units × £5 = £500

Closing inventory = £500

Question 6

Advantages may include:

  • lower storage costs;
  • less capital tied up in inventory;
  • reduced risk of obsolete inventory; and
  • potentially improved inventory efficiency.

Disadvantages may include:

  • increased dependence on suppliers;
  • greater risk from delivery delays;
  • possible shortages; and
  • difficulty responding to unexpected increases in demand.
Question 6

No. JIT is an inventory-management approach rather than a valuation method.

Question 7

Not necessarily. FIFO is an accounting assumption used to determine the cost assigned to inventory issued and inventory remaining.

Question 8

No. Excess inventory may increase storage costs and tie up capital.

Question 9

No. JIT aims to minimise inventory and coordinate deliveries closely with requirements, but businesses may still need appropriate inventory levels or contingency arrangements.

Question 10

Under FIFO, the earliest purchases are assigned to units issued first. Therefore, the units remaining in inventory are generally assigned the costs of more recent purchases.

Question 11

Periodic AVCO calculates one average using the inventory available over the period.

Perpetual AVCO recalculates the average after each purchase.

Therefore, the timing of purchases and issues can produce different closing-inventory values.

Question 12

JIT could reduce storage costs and capital tied up in inventory.

However, unreliable suppliers could create shortages and interrupt production or sales.

The business would therefore need to assess whether the expected benefits outweigh the operational risks.

How This Topic Appears in the Examination

This topic may be assessed through:

  • FIFO calculations;
  • periodic AVCO calculations;
  • perpetual AVCO calculations;
  • comparison of inventory valuation methods;
  • explanation of JIT;
  • advantages and disadvantages of JIT;
  • business scenarios involving inventory management; and
  • evaluation of inventory-management decisions.

For calculation questions, students should:

Identify the method → Organise the inventory data → Calculate carefully → Check the closing quantity → Verify the total value.

For decision-making questions:

Identify → Explain → Apply → Evaluate.

Self-Assessment Checklist​

  • I can explain why inventory is valued.
  • I can explain FIFO.
  • I can calculate closing inventory using FIFO.
  • I can explain AVCO.
  • I can calculate periodic AVCO.
  • I can calculate perpetual AVCO.
  • I can distinguish between periodic and perpetual AVCO.
  • I can explain JIT.
  • I can identify advantages and disadvantages of JIT.
  • I can apply JIT to a business situation.
  • I can evaluate inventory-management decisions.
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