A steel fabricator in Chennai called me with a strange problem. His accountant said the company was profitable. His bank account said otherwise. Revenue was up, order book was full, but cash was tight and margins felt thin. After two days of digging, we found the root cause: his inventory was valued using the weighted average method in Tally, but his actual material consumption pattern was FIFO. The difference in valuation — roughly ₹14 lakh over a year — was distorting his profit numbers and his quoting decisions.
He didn't have a business problem. He had a costing method problem. And he'd never thought about it because, like most Indian manufacturers, he'd accepted whatever default his accountant or Tally had set up on day one.
Your inventory costing method shapes your reported profit, your material cost per job, your quoting accuracy, your tax liability, and your decision-making — all silently, all the time. Most manufacturers never consciously choose a costing method. They inherit one and never question it. That's a mistake worth fixing.
What inventory costing actually does
When you buy the same material at different times, you pay different prices. Steel purchased in January at ₹62/kg and steel purchased in March at ₹68/kg sit on the same rack. When you issue 100 kg to production, which cost do you assign — ₹62, ₹68, or something in between?
That question is the entire domain of inventory costing. The answer determines:
- Your material cost per job — which affects whether you think the job was profitable
- Your inventory valuation — which affects your balance sheet and your reported profit
- Your quoting decisions — because you set prices based on what you think your costs are
- Your tax liability — because your closing stock value affects your taxable income
There are three primary methods, and each gives you a different answer to the same question.
FIFO: First In, First Out
FIFO assumes you use the oldest stock first. The material that arrived first is issued first, and its purchase cost is assigned to the job.
How FIFO works — a worked example
You manufacture SS304 tanks. Here are your stainless steel purchases and issues over two months:
Purchases:
| Date | Qty (kg) | Rate (₹/kg) | Total (₹) |
|---|---|---|---|
| Jan 5 | 500 | ₹280 | ₹1,40,000 |
| Jan 22 | 300 | ₹295 | ₹88,500 |
| Feb 10 | 400 | ₹310 | ₹1,24,000 |
Total stock: 1,200 kg. Total cost: ₹3,52,500.
Issue: Feb 15 — 600 kg issued to Job #2045
Under FIFO, the first 500 kg comes from the Jan 5 batch (at ₹280/kg) and the next 100 kg from the Jan 22 batch (at ₹295/kg).
Material cost for Job #2045:
- 500 kg × ₹280 = ₹1,40,000
- 100 kg × ₹295 = ₹29,500
- Total: ₹1,69,500 (effective rate: ₹282.50/kg)
Remaining stock after issue:
- 200 kg from Jan 22 batch @ ₹295 = ₹59,000
- 400 kg from Feb 10 batch @ ₹310 = ₹1,24,000
- Total remaining: 600 kg valued at ₹1,83,000 (effective rate: ₹305/kg)
Notice what happened: the job got the lower cost (older material), and the remaining inventory reflects the higher, more recent prices. This is the fundamental characteristic of FIFO.
When FIFO makes sense
Perishable or shelf-life sensitive materials: Pharmaceutical manufacturers, food processing units, and anyone working with chemicals that degrade over time should use FIFO — both physically and for costing. You want to use the oldest stock first to avoid expiry waste.
Industries with steadily rising prices: When material prices trend upward (which has been the general trend for metals in India over the past several years), FIFO assigns the lower, older cost to your current jobs. This means your reported cost of goods sold (COGS) is lower, your reported profit is higher, and your closing stock is valued at higher, more recent prices — which is closer to replacement cost.
Companies that want higher reported profit: Because FIFO in a rising-price environment reports lower COGS and higher profit, companies seeking bank loans, investor confidence, or higher valuations sometimes prefer FIFO. The profit is real — you did buy the material cheaper — but it's important to understand that your next batch will cost more.
FIFO pitfalls for Indian manufacturers
Higher tax liability in rising markets: Higher reported profit means higher taxable income. Under the Income Tax Act, your closing stock valued at recent (higher) rates increases your taxable profit. For an MSME operating on thin margins, this can create a cash flow squeeze — you show profit on paper but the cash went to paying more for the next material purchase.
Tracking complexity: True FIFO requires tracking which batch of material was issued to which job. If you have 15 batches of a single material on your shelves, you need to track 15 different cost layers. On paper or in a basic spreadsheet, this is extremely tedious. In software, it's automatic.
LIFO: Last In, First Out
LIFO is the opposite of FIFO. It assumes you use the newest stock first. The most recently purchased material is assigned to the job first.
How LIFO works — same example
Using the same purchases as above:
Issue: Feb 15 — 600 kg issued to Job #2045
Under LIFO, the first 400 kg comes from the Feb 10 batch (at ₹310/kg) and the next 200 kg from the Jan 22 batch (at ₹295/kg).
Material cost for Job #2045:
- 400 kg × ₹310 = ₹1,24,000
- 200 kg × ₹295 = ₹59,000
- Total: ₹1,83,000 (effective rate: ₹305/kg)
Remaining stock after issue:
- 500 kg from Jan 5 batch @ ₹280 = ₹1,40,000
- 100 kg from Jan 22 batch @ ₹295 = ₹29,500
- Total remaining: 600 kg valued at ₹1,69,500 (effective rate: ₹282.50/kg)
Compare: the same 600 kg issue costs ₹1,83,000 under LIFO vs ₹1,69,500 under FIFO. That's a ₹13,500 difference (8%) — purely from the costing method. The physical material is identical. Only the cost assignment changed.
When LIFO makes sense
In theory: LIFO matches current material costs against current revenue, giving a more realistic picture of current-period profitability. If you're quoting and selling at today's prices, it makes sense to cost your production at today's prices too.
In practice for Indian manufacturers: LIFO is rarely used in India for several important reasons.
Why LIFO is uncommon in India
1. Indian Accounting Standards (Ind AS) do not permit LIFO. The Indian Accounting Standards, aligned with IFRS, explicitly prohibit LIFO for financial reporting. Companies that follow Ind AS (mandatory for listed companies and companies above certain thresholds) cannot use LIFO.
2. The Income Tax Act discourages LIFO. While the Income Tax Act doesn't explicitly ban LIFO, tax authorities prefer FIFO or weighted average. Using LIFO in a rising-price environment reduces reported profit and therefore tax liability, which invites scrutiny.
3. Tally defaults to weighted average or FIFO. Tally, the dominant accounting software in Indian SMEs, supports FIFO and weighted average out of the box. LIFO requires manual configuration or workarounds. Since most small manufacturers use whatever Tally defaults to, LIFO rarely gets implemented.
4. GST implications. GST input credit is claimed on a transaction-by-transaction basis, not on a costing method basis. However, your stock valuation method affects your closing stock declaration, which flows into your income tax return. LIFO-based low stock valuations can create inconsistencies that flag during assessment.
Bottom line: Unless you have a specific, accountant-approved reason to use LIFO, it's not the right choice for most Indian manufacturers. The rest of this article focuses on the practical choice: FIFO vs Weighted Average.
Weighted Average: The middle path
Weighted average recalculates the average cost of your stock after every purchase. Every unit in stock has the same cost — the weighted average of all purchases.
How weighted average works — same example
Starting position after Jan 5 purchase:
- 500 kg @ ₹280/kg. Average cost: ₹280/kg.
After Jan 22 purchase (300 kg @ ₹295/kg):
- Total stock: 800 kg
- Total cost: ₹1,40,000 + ₹88,500 = ₹2,28,500
- New average cost: ₹2,28,500 ÷ 800 = ₹285.63/kg
After Feb 10 purchase (400 kg @ ₹310/kg):
- Total stock: 1,200 kg
- Total cost: ₹2,28,500 + ₹1,24,000 = ₹3,52,500
- New average cost: ₹3,52,500 ÷ 1,200 = ₹293.75/kg
Issue: Feb 15 — 600 kg issued to Job #2045
Under weighted average, all 600 kg is issued at ₹293.75/kg.
Material cost for Job #2045:
- 600 kg × ₹293.75 = ₹1,76,250
Remaining stock after issue:
- 600 kg @ ₹293.75 = ₹1,76,250
Comparing all three methods side by side
| Method | Job Cost (600 kg) | Remaining Stock Value (600 kg) | Effective Rate Assigned to Job |
|---|---|---|---|
| FIFO | ₹1,69,500 | ₹1,83,000 | ₹282.50/kg |
| LIFO | ₹1,83,000 | ₹1,69,500 | ₹305.00/kg |
| Weighted Average | ₹1,76,250 | ₹1,76,250 | ₹293.75/kg |
The same 600 kg of the same material on the same job — and the cost varies by ₹13,500 depending on your method. Scale this across a year of production with hundreds of jobs, and the cumulative impact on your reported profit, your job-wise margins, and your quoting accuracy is substantial.
Pros and cons for Indian manufacturers
FIFO
| Pros | Cons |
|---|---|
| Closing stock reflects recent (realistic) market prices | Higher reported profit in rising markets = higher tax |
| Required for perishable/shelf-life materials | Requires batch-level tracking |
| Accepted by Income Tax and Ind AS | Can make current jobs look cheaper than they really are |
| Better for bank loan applications (higher asset value) | Complex to implement manually |
| Matches physical flow in most factories | — |
Weighted Average
| Pros | Cons |
|---|---|
| Simple to understand and implement | Doesn't reflect actual physical material flow |
| Smooths out price fluctuations — no sharp cost jumps | Closing stock may not reflect current market value |
| Tally default — no configuration needed | Can mask price trends (you don't see the impact of a rate hike immediately) |
| Accepted by Income Tax and Ind AS | Less accurate for job costing when prices are volatile |
| Easy to explain to non-accountants | — |
| No batch tracking required | — |
What Tally uses by default
Since Tally is the de facto accounting standard for Indian SMEs, it's worth understanding its default behaviour.
Tally Prime (latest versions):
- Default inventory valuation method: Weighted Average
- Can be changed to FIFO at the company level or stock group level
- LIFO is available but rarely configured
- The setting is in: Gateway → Alter → Stock Group → Method of Costing
Practical implication: If you've never changed the setting, your Tally is running weighted average. Every stock report, every balance sheet, every profit & loss statement — all based on weighted average valuation.
This is fine for most manufacturers. But if you're in an industry where FIFO is more appropriate (pharma, food, chemicals), or if you want more accurate job costing during periods of high price volatility, you should consciously choose your method rather than accepting the default.
A common Tally mismatch
Many manufacturers run Tally for accounting and a separate system (or Excel) for production and quoting. The quoting system uses one costing logic (often the "latest rate" or a manually updated rate card) while Tally uses weighted average. This means:
- Your quote says the job costs ₹2,85,000 in material
- Tally says the job consumed ₹2,93,000 in material (because Tally used weighted average, which includes older, cheaper stock that pulled the average below the latest rate, or the reverse)
- Your reported margin doesn't match your expected margin
- Nobody can explain the difference
The fix is simple: use the same costing method for quoting and accounting. If Tally runs weighted average, your quoting system should use weighted average too. If you switch Tally to FIFO, your quoting should follow.
GST and Income Tax implications
GST
GST itself doesn't mandate a specific inventory costing method. Input tax credit (ITC) is claimed on a per-invoice basis, so the costing method doesn't affect your GST returns directly.
However, your costing method affects your closing stock valuation, which appears in your annual accounts and your income tax return. The income tax assessment may cross-reference your stock valuation with your GST filings (GSTR-9 annual return includes stock declarations). Inconsistencies between your reported stock value and your GST-linked purchase records can trigger scrutiny.
Practical advice: Whichever method you choose, be consistent. Don't change methods mid-year. If you must change, do it at the start of a financial year and disclose the change in your financial statements.
Income Tax
Under Section 145 of the Income Tax Act, the method of accounting (including inventory valuation) must be consistently followed. The ICDS (Income Computation and Disclosure Standards) provide guidance:
- ICDS II allows FIFO and weighted average for inventory valuation
- LIFO is not explicitly allowed under ICDS
- Consistency is mandatory — you can't switch methods to minimize tax
- Any change in method requires disclosure and may invite assessment
The tax impact in numbers:
Consider a manufacturer with ₹1.5 crore annual material consumption and ₹25 lakh average inventory.
In a year where average material prices rose by 12%:
| Method | Closing Stock Value | COGS | Reported Profit Impact |
|---|---|---|---|
| FIFO | ₹28 lakh (higher — reflects recent prices) | Lower | Higher profit by ~₹3 lakh |
| Weighted Average | ₹26.5 lakh (moderate) | Moderate | Moderate profit |
At a 25% effective tax rate (for MSME companies under Section 115BAA), the ₹3 lakh profit difference translates to roughly ₹75,000 in additional tax liability under FIFO. That's real money for a small manufacturer.
This doesn't mean you should choose a method purely for tax optimization — that invites problems. But you should understand the tax implications of your choice.
When to use FIFO — industry-specific guidance
Pharmaceutical manufacturing
FIFO is not optional for pharma — it's a regulatory requirement. Active pharmaceutical ingredients (APIs) and excipients have expiry dates. You must use the oldest stock first to minimize expiry waste. FIFO costing aligns the cost accounting with the physical flow.
A pharma manufacturer in Hyderabad's Genome Valley runs strict FIFO with batch tracking. Every gram of API is traced from receipt to consumption. The costing method is FIFO because the physical flow is FIFO. There's no disconnect.
Food processing
Same logic as pharma. Ingredients with shelf life must be used FIFO. A spice processor in Kochi or a snack manufacturer in Indore will rot inventory if LIFO is followed physically. FIFO costing matches the physical reality.
Chemicals and paints
Many chemical raw materials have shelf life or stability concerns. Resin, hardeners, catalysts, and solvents degrade over time. FIFO ensures the oldest stock is consumed first and costed first.
Electronics assembly
Components like electrolytic capacitors, thermal compounds, and flux have shelf life. FIFO is standard for EMS (Electronics Manufacturing Services) companies in Noida, Bengaluru, and Chennai.
When to use weighted average — industry-specific guidance
Steel and metal fabrication
A fabrication shop in Pune buys MS steel from multiple suppliers at slightly different rates. The steel sits in the same rack, gets cut on the same machine, and is physically indistinguishable between batches. Tracking which batch went to which job is impractical and adds no value.
Weighted average is the natural choice. The average cost is applied to every job, which smooths out the purchase-to-purchase rate variations and gives a stable cost base for quoting.
Plastics and polymer processing
An injection moulding shop in Delhi NCR buys PP granules from multiple suppliers. The granules are mixed in the hopper. There's no physical batch separation. Weighted average costing matches the physical reality — the material is literally averaged in the process.
General fabrication and machining
Most job shops, tool rooms, and general engineering workshops benefit from weighted average. The material flow doesn't follow strict batch discipline, multiple purchases are consumed interchangeably, and the simplicity of weighted average outweighs the theoretical precision of FIFO.
Textile manufacturing
Yarn, fabric, and dyes from different lots are often blended in processing. Weighted average smooths the cost variations across lots and gives a consistent cost base.
How your costing method affects quoting accuracy
This is where the choice of costing method becomes operationally critical, not just an accounting decision.
When you build a quote, you need to assign a material cost. That cost comes from somewhere — and ideally, it should reflect the cost you'll actually incur when you produce the order.
The quoting dilemma
- FIFO cost tells you what the oldest stock cost. If prices have risen, this understates your replacement cost. You quote low, win the order, produce it with material you'll need to replace at a higher price, and your margin shrinks.
- Weighted average cost tells you the blended cost of all stock. It's more current than FIFO but still lags behind the latest purchase price if you have old, cheap stock in the system.
- Latest purchase rate tells you what you last paid. It's the most current number but doesn't account for cheaper stock you already have.
The practical recommendation for quoting:
For quoting purposes, use the higher of weighted average cost and latest purchase rate. This protects your margin in rising markets without overpricing in stable markets.
Here's why: if your weighted average is ₹290/kg and your latest purchase is ₹310/kg, prices are rising. Quote at ₹310/kg because that's what your next purchase will cost. If your weighted average is ₹290/kg and your latest purchase is ₹285/kg (because you found a cheaper supplier), prices are stable or falling. Quote at ₹290/kg because your inventory still carries the cost of earlier, more expensive purchases.
Many quoting systems use a simple "latest rate" lookup. This is better than using a stale rate card but worse than an intelligent approach that considers both your current stock cost and market direction.
Practical steps: choosing and implementing your method
Step 1: Understand your current method
Check what Tally is configured to use. If you're unsure, your accountant or CA will know. Most likely, it's weighted average.
Step 2: Evaluate fit
Ask yourself:
- Do my materials have shelf life or batch-sensitive properties? → FIFO
- Are my materials commodity-type, physically interchangeable between batches? → Weighted Average
- Is my industry regulated to use a specific method? → Follow the regulation
- Am I happy with Tally's default, and does my accountant agree? → Stick with weighted average
Step 3: Align quoting with accounting
Whatever method you choose, make sure your quoting system uses the same logic. The number one source of "margin surprise" in Indian manufacturing is a disconnect between quoted cost and booked cost. If your quote uses latest rate but Tally uses weighted average, your reported job margin will never match your expected job margin.
Step 4: Document your choice
Note your chosen method, the date of adoption, and the rationale. This documentation helps during tax assessments, bank loan applications, and internal audits. Under ICDS, consistency is required and changes must be disclosed.
Step 5: Review annually
At the start of each financial year, review whether your costing method still makes sense. If your business has shifted (new product lines, different materials, different market conditions), your costing method might need to change. Any change should be made at the start of the financial year with proper disclosure.
The hidden cost of not choosing
The most expensive option is not choosing at all — which is what most Indian manufacturers do. They accept whatever default was configured when Tally was set up, use a different logic for quoting, and never reconcile the two. The result is reported profits that don't match cash flow, job margins that look fine in the quote but disappointing in the books, and a persistent sense that "the numbers don't add up."
The numbers don't add up because the costing method is inconsistent or inappropriate. Fix the method, align it across quoting and accounting, and the numbers start making sense.
A packaging manufacturer in Mumbai switched from an unexamined weighted average to a conscious FIFO implementation (appropriate for their shelf-life-sensitive raw materials). Within one quarter, their reported job margins became consistent with their quoted margins. The variance dropped from 8-12% to under 3%. They didn't become more profitable — they became more accurate about their profitability. And accuracy is the prerequisite for improvement.
QuoteERP supports FIFO, LIFO, and weighted average costing — and ensures your quoting engine uses the same method as your inventory valuation, so your quoted margins match your actual margins. If you want to stop the guesswork and see real material costs flowing into real quotes, get in touch at quoteerp.com/contact.