Our last post on inventory management explored various techniques to adopt for proper and effective management of your business inventory. Now let us take a look at 3 commonly used accounting methods for inventory valuation.
Your inventory is the most important component of your current assets and so it is essential to do a proper valuation for record keeping purposes. Inventory valuation is the practise of placing a monetary value on your inventory items. Without this, it is difficult to ascertain how much more goods you need, how well sales are doing and prepare your financial statements.
Inventory includes items which are held for sales or items to be used in the production of goods intended for sales. They can be classified under raw materials, work in progress, and finished goods.
Due to the fact that inventory items are constantly being sold and restocked, and prices fluctuate, any of the methods explained below can be adopted to help determine the cost of goods that have been sold and not yet sold. Cost of goods sold refers to the cost of goods that have been sold to customers( reported in the income statement) while ending inventory is the cost of goods that have been bought but not yet sold (reported in the balance sheet).
First In First Out (FIFO)
Here, the assumption is that materials are sold in the order in which they were produced or purchased. This means the materials received first are sold first. Therefore, goods sold are valued at the cost price of the first stock.
The cost of the older inventory is then charged to cost of goods sold first and goods which are purchased or produced later are charged to the ending inventory.When prices of good increase, cost of goods sold is lower because the old price for the first stock is used while inventory is higher. Therefore, your net income is higher.
Last In First Out (LIFO)
This method is the exact opposite of FIFO. Under this method, the assumption is that products are priced in the reverse order of purchase i.e. the price of the latest batch produced or purchased is used first. Therefore, newer inventory is charged to cost of goods sold while older inventory remains as inventory.
When prices of goods increase, cost of goods sold here is higher because it is made up of higher priced goods (new inventory) and inventory remains lower. Therefore, this lowers the net income. This also doesn’t provide a good indication of the ending inventory as valuation is priced lower than today’s prices. However, most companies used to adopt this method because of its effect on reducing tax price paid.
Weighted Average Cost
This method is perhaps logical and straightforward. Here, it is expected that batches of inventory would get mixed up. Weighted average cost per unit is calculated for the entire inventory available and used to get your cost of goods sold and ending inventory. It is calculated as:
Weighted Average Cost Per Unit= Total Cost of goods in Inventory/Total Units in Inventory
In periods of price increase, this method gives better results because it evens out fluctuations in price by taking the average of prices of various batches in your inventory.
Let’s imagine a shoemaker produces 20 shoes at the cost of N2000 on Tuesday. Then, he produces 30 more at the cost of N3000 on Thursday.
FIFO: This states that if the shoemaker sold 20 shoes on Friday, the cost of goods sold will be N2000 on the income statement because that was the cost of the first set of shoes to be produced. N3000 for the set left will appear on the balance sheet as ending inventory.
LIFO: As the exact opposite of FIFO, the COGS will be the N3000 for the set that was produced last while inventory will be N2000.
Weighted Average: As stated in the calculation above
Total cost of goods in inventory/Total units in inventory
(20×2000) +(30×3000)/(20+30) = 130000/5 + N2600
To help you learn better, here is a fun game you can play with to understand the inventory valuation methods discussed.
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