Inventory Valuation

Inventory Valuation,Methods,Examples

Inventory Valuation:

Inventory valuation is the cost associated with an entity’s inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation, and can also be used as collateral for loans. This valuation appears as a current asset on the entity’s balance sheet.

The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported into the proper place for sale. You are not allowed to add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are:

  • Direct labor
  • Direct materials
  • Freight
  • Handling
  • Import duties
  • Production overhead

Inventory Valuation Methods

Business owners may recognize the classic inventory valuation methods (i.e. FIFO, LIFO, Weighted Average, etc.), but few know the direct impact that each method will have on their financials. The choice between inventory valuation methods can lead to drastic differences in net income, cost of goods sold, and ending inventory. Are the differences due to some sort of accounting magic? Certainly not! As accountants, we must analyze each method and apply the method that most accurately reflects periodic income. To help accountants with this decision, I will go through three common valuation methods and demonstrate the unique impact that each method will have on the financial statements.

a)First In, First Out(FIFO)

FIFO is based on the principle that the first inventory goods received will be the first inventory goods sold. FIFO results in the highest ending inventory, the lowest cost of goods sold, and the highest net income. This is because the oldest and lowest costs are allocated to cost of goods sold. Ending inventory is valued with the newest and highest cost; which most accurately approximates replacement cost. Net income will increase because the lowest costs were used; which is not an accurate reflection of current cost to current revenue. Another unique factor FIFO offers, is the ability to have the same amounts for ending inventory and cost of goods sold regardless of the use of periodic or perpetual inventory systems.

b)Last In, First Out(LIFO):

LIFO is based on the principle that the last inventory goods received will be the first inventory goods sold. In periods of rising prices, LIFO will result in the lowest ending inventory, the highest cost of goods sold, and the lowest net income. Ending inventory is smaller because the newest and highest prices are sold first, leaving the oldest and cheapest inventory on the books. Cost of goods sold is high because the newest and most expensive inventory is sold first. Net income is the lowest because revenues are matched with the highest inventory costs. LIFO eliminates holding gains because we are selling inventory with the newest cost.

LIFO does produce different ending inventory and COGS amounts when choosing between periodic and perpetual inventory systems. When using periodic inventory systems, costs from the end of the period are used first, regardless of when inventory was sold within that period. This results in the highest COGS and a lower ending inventory. When using perpetual inventory systems, the date inventory is sold determines which inventory costs are used. This results in a lower COGS and a higher ending inventory.

There are several important items to note before using LIFO. First, LIFO is susceptible to incurring obsolete inventory. This is because older inventory will continue to sit on the shelves and may become obsolete over time. Second, if LIFO is used in tax reporting, then LIFO is required to be used for financial statement preparation under US GAAP. Finally, International Financial Reporting Standards prohibit the use of LIFO. Each of these factors should be considered before adopting LIFO.

c)Weighted Average Method(WAM):

Weighted average allocates the average period cost of all homogenous goods in inventory to individual items. At the end of each period, identical inventory items are combined for a total inventory cost. The total inventory cost is divided by the units of inventory available. This calculation provides us the average inventory cost per unit. COGS are determined by multiplying the average cost per unit by the amount of goods sold. Ending inventory is determined by subtracting COGS from the total cost of inventory (not the average!). Weighted average provides a middle ground for determining net income, ending inventory, and COGS.

It is important to note that QuickBooks only permits the use of weighted average. If you decide to use another inventory valuation method, you will have to manually override QuickBooks with journal entries.

Inventory management in your accounting system can be very challenging and confusing. Improper handling of inventory can cause wild swings in your financial reports. TGG Accounting can help clean up or implement these kind of best practices. Call us today.

Example:

(past question-2001)

The following information is concerning Pokhara Metal Inc.

 

Units

Unit cost

Beginning Inventory

Purchases

March 5

June 12

August 23

October 2

200

 

300

400

250

150

Rs.10

 

Rs.11

Rs.12

Rs.13

Rs.15

 

Pokhara Metal Inc. employs a perpetual system, sold 1000 units for rs.22 each during the year. Sale occurred on the following dates.

 

Units

Feb 2

April 30

July 7

September 6

December 3

150

200

200

300

150

 

Calculate the ending inventory and cost of goods sold for each of the following methods.

a.Weighted Average

b.FIFO

c.LIFO

d.Which method can minimize the tax obligation? Explain.

Ans:

                                                          Pokhara Metal Inc.

                                 Calculation of Ending Inventory and Cost of Goods sold

                                                Perpetual Inventory System

                                                Weighted Average Method

Date Purchases Sales Balance
Unit  Cost Amount unit cost amount unit cost amount
Beginning             200 10 2000
12-Feb       150 10 1500 50 10 500
5-Mar 300 11 3300       350 10.86 3801
30-Apr       200 10.86 2172 150 10.86 1629
12-Jun 400 12 4800       550 11.689 6428.95
7-Jul       200 11.689 2337.8 350 11.689 4091.15
23-Aug 250 13 3250       600 12.235 7341
6-Sep       300 12.235 3670.5 300 12.235 3670.5
2-Oct 150 15 2250       450 13.16 5922
3-Oct       150 13.16 1974 300 13.16 3948

 

b.          

                                                      Pokhara Metal Inc.

                                 Calculation of Ending Inventory and Cost of Goods sold

                                                Perpetual Inventory System

                                                    FIFO    Method

Date

     Purchases

          Sales

     Balance

Unit

Cost

Amount

unit

cost

amount

unit

cost

amount

Beginning

 

 

 

 

 

 

200

10

2000

12-Feb

 

 

 

150

10

1500

50

10

500

5-Mar

300

11

3300

 

 

 

 

50

300

 

10

11

 

500

3300

30-Apr

 

 

 

 

50

150

 

10

11

 

500

1650

 150

 11

 1650

12-Jun

400

12

4800

 

 

 

 

 150

400

 

 11

12

 

1650

4800

7-Jul

 

 

 

 

 150

50

 

11

12

 

1650

600

 

 

 350

 

 

12

 

 

4200

23-Aug

250

13

3250

 

 

 

 350

250

12 

13

 4200

3250

6-Sep

 

 

 

 300

 12

 3600

 

 50

250

 

12

13

 

600

3250

2-Oct

 

150

 

15

 

2250

 

 

 

 

 50

250

150

 12

13

15

 600

3250

2250

3-Dec

 50

100

 12

13

 600

1300

 

150

 

13

 

1950

 

150

15

2250

  1100 13600 1000 11400

300

4200

 

c.                                       

                                                    Pokhara Metal Inc.

                                 Calculation of Ending Inventory and Cost of Goods sold

                                                Perpetual Inventory System

                                                        LIFO    Method

Date

Purchases

Sales

Balance

Unit

Cost

Amount

unit

cost

amount

unit

cost

amount

Beginning

 

 

 

 

 

 

200

10

2000

12-Feb

 

 

 

150

10

1500

50

10

500

5-Mar

300

11

3300

 

 

 

 

50

300

 

10

11

 

500

3300

30-Apr

 

 

 

 200

 11

 2200

 

 50

100

 

10

11

 

500

1100

12-Jun

 

400

 

12

 

4800

 

 

 

 

 

 50

100

400

 

10

11

12

 

500

1100

4800

     7-Jul

 

 

 

 

 

 200

 

 

 12

 

 

2400

 

 

 50

100

200

 10

11

12

 500

1100

2400

23-Aug

 

 

 

 

 

250

 

 

 

 

 

13

 

 

 

 

 

3250

 

 

 

 

 

 

 

 

 

 

50

100

200

250

 

 

10

11

12

13

 

 

500

1100

2400

3250

 

 

6-Sep

 

 

 

 

 250

50

 13

12

 3250

600

 

50

100

150

 

 10

11

12

 

500

1100

1800

2-Oct

 

 

150

 

 

15

 

 

2250

 

 

 

 

 

 

 50

100

150

150

 

10

11

12

15

 

500

1100

1800

2250

3-Dec

 

 

 

 

 150

 

 15

 

 2250

 

 

50

100

150

 

10

11

12

 

500

1100

1800

 

1100   13600

1000

 

12200

300

 

3400

 

d.)   Tax is paid on the  basis of net income.Net income inversely relates with expenses ie;income increases with decrease in expenses and vice-versa.Cost of goods sold is any expenses incurred to make the intended goods into selling conditions which is deducted from sales revenue to ascertain gross profit.Thus,higher the cost of goods sold,lower the net income before income tax and vice-versa .In the given case ,cost of goods sold is highest ie;rs 12200 under LIFO method in which tax obligation can optimally be minumized.

 

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