Financial Management & Cost Accounting

Lesson 47. VALUATION OF INVENTORY

Module 8. Costing

Lesson 47

VALUATION OF INVENTORY

47.1 Valuation of Inventory

The method of inventory valuation is of great importance to management for the following reasons. It determines the amount of firm’s investment in inventory, i.e., how much money has been blocked and influences the amount of firm’s reported income, i.e., profit. Cost accounting (records) rules provide that ‘inventory’ should be valued at cost of production.

47.2 Valuation of Material

Cost accounting records rules provide that raw material, stores and spare parts would always be valued at cost while in financial accounts it is valued at lower of the cost or market price. The term ‘value’ includes net invoice price (after deduction of trade discount and allowances) plus all direct charges such as freight, duty, cleaning charges, carriage etc. As may have been incurred before the materials reach the factory.

47.3 Methods of Pricing Issues

1.First-in First-out Method

The FIFO assumes that items first received are the first to be issued and that the requisitions are priced at the cost at which these items were placed in stock. It should be emphasized, that the pattern of cost flow does not necessarily coincide with the actual flow pattern of the materials. FIFO method does not mean that oldest materials are necessarily used first. It simply means that the oldest costs used for accounting purpose first regardless of actual material flow.

Advantages

1.This method is not based on approximations and estimates.

2. It conforms to sound principles of economics and business.

3. It is a convenient method to be used for pricing of material issues under any circumstances.

4. It is based upon a clear-cut assumption as to the movement of goods in storeroom.

Disadvantages

1. This method involves a lot of calculation work.

2. For pricing one requisition, more than one price may have to be adopted.

3. Cost may be distorted, if the prices of different lots of materials are used for pricing issues to different batches of production.

4. In a period of fluctuating prices, the costs of issues do not represent market price.

2. Last-in-First-out Method

The LIFO method of costing is based on the assumption that the last items purchased are the first to be used. It should be emphasized that the pattern of cost flow does not necessarily coincide with the actual flow pattern of materials.

Advantages

1. The cost of material is started more nearly at current market price and, thus, unrealized inventory profits are not reflected in the accounts.

2. It conforms to the principle that cost should be related to current price levels.

3. Unlike FIFO method, this method does not result into unrealized profit due to inflationary trends.

Disadvantages

1.This method is considerable clerical work.

2.The balance at hand is valued at the oldest prices which may not correspond at all with prevailing market price.

3.Under falling prices, issues are price at lower prices and stocks are valued at higher rates.

4.Sometimes more than one price has to be adopted for pricing a requisition.

5. This method is not acceptable to income tax authority.

6. This method is suitable when items of material to be priced are few in number.

3. Weighted Average Method

Under this method, the quality of material purchased during a particular period is also taken into account. This method is also used for a particular period. The weighted average price is calculated by dividing the total cost of the material purchased during the accounting period. In which the material to be priced is used, by the total quantity of material purchased during that period.

Total cost of purchases during the accounting period

Weighted Average Price = ---------------------------------------------------------------------

Total quantity purchased during accounting period

This method takes into account both the cost and the quantity of the material purchased during the accounting period.

Advantages

1. It is simple to operate.
2. It averages out the effect of price fluctuations.
3. It can be advantageously used in process industry.

 

Disadvantages

1.This method cannot be used in job order industry, where each individual order must priced at each stage up to completion.
2. The costing of material issued gets delayed up to the end of the period and this result in heavy burden on clerical staff in the end.
3. Under this method also the closing stock will not correspond to the conventional accounting of valuation of stock, that is, cost or market price whichever is lower.

 

Example

Prepare a store’s ledger account if the material are issued on FIFO and LIFO bases and find closing inventory

Date	Issued Quantity
4/3/’10	50
10/3/’10	25
20/3/’10	125
31/3/’10	50

Solution

Solution according to First In First Out method

Date	Received			Issued			Balance
	Quantity	Rate	Value	Quantity	Rate	Value	Quantity	Rate	Value
1/3/2010	100	10	1000	−	−	−	100	10	1000
4/3/2010	−	−	−	50	10	500	50	10	500
10/3/2010	−	−	−	25	10	250	25	10	250
18/3/2010	150	9	1350	−	−	−	25	10	250
							150	9	1350
20/3/2010	−	−	−	25	10	250	50	9	450
				100	9	900
30/3/2010	50	8	400	−	−	−	50	9	450
							50	8	400
31/3/2010	−	−	−	50	9	450	50	8	400
Value of inventory/Value of closing stock=400

Solution according to LIFO method

Date	Received			Issued			Balance
	Quantity	Rate	Value	Quantity	Rate	Value	Quantity	Rate	Value
1/3/2010	100	10	1000	−	−	−	100	10	1000
4/3/2010	−	−	−	50	10	500	50	10	500
10/3/2010	−	−	−	25	10	250	25	10	250
18/3/2010	150	9	1350	−	−	−	25	10	250
							150	9	1350
20/3/2010	−	−	−	125	9	1125	25	10	250
							25	9	225
30/3/2010	50	8	400	−	−	−	25	10	250
							25	9	225
							50	8	400
31/3/2010	−	−	−	50	8	400	25	10	250
							25	9	225
Value of inventory/ Value of closing stock=475

Example

The following transactions took place in respect of a material item:

DATE	RECEIPTS (QTY)	RATE PER UNIT (RS)	ISSUS (QTY)
2 MARCH	200	2.00	-
10 MARCH	300	2.40	-
15 MARCH	-	-	250
18 MARCH	250	2.60	-
20 MARCH	-	-	200

Prepare the priced ledger sheet pricing the issues at weighted average rate.

Solution

STORE LEDGER SHEET

Solution according to weighted average method

DATE	RECEIPTS			ISSUES			BALANCE
	QTY	RATE RS	COST RS	QTY	RATE RS	COST RS	QTY	RATE RS	COST RS
2 MAR	200	2.00	400	-	-	-	200	2.00	400
10 MAR	300	2.40	720	-	-	-	500	2.40	1120
15 MAR	-	-	-	250	2.24	560	250	2.24	560
18 MAR	250	2.60	650	-	-	-	500	2.42	1210
20 MAR	-	-	-	200	2.42	484	300	2.42	726