The prices of most kinds of merchandise change during the year. As a result, units of a specific item of inventory are purchased on different dates at different prices. One has, therefore, to make an assumption about the order in which units have been sold so that the cost of goods available for sale can be allocated between the ending inventory and cost of goods sold.

Inventory Valuation

1. Inventory Includes:-

Raw Materials

Work-In-Progress

Finished Goods

2. The objective of inventory valuation is to:

Determine the Op. Income

Value the cost of goods held on he balance sheet.

3. Fundamental principle is to value closing stock at cost or market price whichever is lower

4. For Costing purpose, different methods may be followed by different firms

5. Actual issue of goods for sale is always on FIFO (First in, First Out)

Inventory Valuation

Data

Beginning inventory: 8 tyres @ Rs. 100 = Rs. 800

Purchases

July 3 10 Tyres @ Rs. 120 Rs. 1200

July 10 20 Tyres @ Rs. 130 Rs. 2600

July 15 15 Tyres @ Rs. 140 Rs. 2100

July 27 5 Tyres @ Rs. 150 Rs. 750

Available 50 Tyres Rs. 7,450

For sale 8 Tyres

58 Tyres

Closing

Inventory 20 Tyres

Sold 38 Tyres

Inventory Valuation

Original cost of each item should be identifiable

Cost of closing stock is calculated by summing of the costs of items on hand.

Appropriate for high priced items.

Assumption

12 tyres are from July 10

8 tyres are from July 15

Closing 12 x 130 = Rs. 1,560

Inventory 8 x 140 = 1,120

Rs. 2,680

Rs. 2,680

Inventory Valuation Methods -Specific Identification

This method assigns to each unit the average cost of the units available for sale during the period.

Cost of closing stock is influenced by all prices-current as well as past.

Average Cost = Rs. 7,450 / 58

Rs. 128.40

Closing

Inventory = 20 x 128.40

= Rs. 2,568

Rs. 2,568

Average Cost Method

It assigns the cost of the last units purchased to the cost of goods sold.

Higher cost of goods sold

Lower profits

Lower Income Tax

LIFO:

Unsold July 1 8 Tyres

July 3 10 Tyres

July 10 2 Tyres

Closing

Inventory = 8 x 100 = Rs. 800

= 10 x 120 = Rs. 1,200

= 2 x 130 = Rs. 260

Rs. 2,260

Rs. 2,260

Last In, First Out Method

This method assumes that each sale is made out of the earliest stock, and closing inventory consists of the most recently purchased goods. When prices are rising,

Profits Higher - Overstated

Higher Tax Liability

Unsold July 15 15 Tyres

July 27 5 Tyres

Closing

Inventory = 15 x 140 = Rs. 2,100

= 5 x 150 = Rs. 750

Rs. 2,850

Rs. 2,850

First In, First Out Method

FIFOThis method is unsuitable in time of rising prices because it leads to inventory profits.

Suppose a trader buys an article for Rs. 100, sells it at Rs. 120 and again buys a replacement at Rs. 120 (due to rising prices. He has made a book profit of Rs. 20. But this book profit is not available to him in cash as it is locked up in inventory.

Still he will have to pay taxes on his profit as well as distribute dividend. For this, finding cash will lead to a deficit in cash position.

LIFOIt is subject to the following criticisms;

a) It is purely a tax-saving device and not a method of recording cost-expiration.

b) This method may be acceptable in times of falling prices.

c) It does not really mean current cost against current revenue If the sales quantity is more than the purchase quantity, a part of the value of opening inventory (historical cost) would also enter the cost of goods sold in the determination of profit.

d) This method does not reflect the actual movement of inventories.

Comparative Cost Schedule

Spl. Ident. Av. Cost FIFO LIFO

Rs. 7,450 7,450 7,450 7,450

2,680 2568 2850 2260

4770 4882 4600 5190

Value of goods available for sale

Less Closing Inventory

Cost of Goods Sold

Comparative Profit Schedule

Assume Sale of 38 tyres @ Rs. 200 each

Spl. Ident. Av. Cost FIFO LIFO

Rs. 7,600 7,600 7,600 7,600

4,770 4,882 4,600 5,190

2,830 2,718 3,000 2,410

Sales

Cost of Goods

Sold

Profit

An Evaluation:

In a period of rising prices, LIFO reports the lowest profit because it charges the highest cost of Goods sold, In contrast, FIFO reports the highest gross profit because it charges the lowest cost to COGS.

The results will be reversed in a period of falling prices. When prices are constant, all the four methods will produce identical results. The method to be selected for use will depend on the balance sheet, the Profit & Loss A/c and income tax.

The CBDT, Govt. of India, does not have any rigid rules for the valuation of inventories for IT purposes. A co. is, therefore, free to choose any method of inventory valuation, including FIFO or LIFO.

Once selected, the method must be adopted consistently every year.