2019-06-21 14:12:04Accountants and Bookkeepers: Accountants and BookkeepersEnglishVarious inventory valuation methods are used to overcome inventory pricing challenge. However, the method that clearly exhibits income...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2019/06/A-woman-doing-the-inventory-at-a-warehouse-using-one-of-the-inventory-valuation-methods-e1561106405259.jpghttps://quickbooks.intuit.com/in/resources/accountants-and-bookkeepers-accountants-and-bookkeepers/inventory-valuation-methods/Inventory Valuation Methods: Comparing LIFO, FIFO And WAC

Inventory Valuation Methods: Comparing LIFO, FIFO And WAC

10 min read

A research study was conducted on 100 Indian Small and Medium Enterprises (SMEs) in the manufacturing sector. The objectives of the study were to:

  • Ascertain inventory valuation methods used by SMEs and
  • Determine the suitability of the inventory valuation method as against the ideal method

These respondents belonged to industries ranging from Chemicals, Pharma to Cement and Furniture. Eventually, the study revealed that 62% of the firms used First In First Out (FIFO) Method to evaluate inventory. However, they used this method without knowing if it was relevant for their industry. Further, 73% of the companies did not know the importance of the relationship between the Profit Before Tax and the closing inventory value.

In addition to this, the study revealed that inventory formed more than 50% of the product cost in case of manufacturing SMEs. Thus, it was evident that inventory valuation is an important aspect of accounting for SMEs. This is because use of incorrect inventory valuation method can lead to incorrect reporting of profit. Eventually, use of such incorrect values may turn out to be risky for SMEs. Further, it can impact the purchase planning and pricing decisions of small scale enterprises.

So, let’s understand how to price inventory in accounting as a small business owner. Also, let’s  figure out what are the various inventory valuation methods that can be used to evaluate inventory.

You May Also Read

Top 4 Inventory Management Tips You Must Know

How To Price Inventories?

There are times when you purchase inventory at different prices during a given accounting period. In such scenarios, it becomes challenging for you to determine cost of goods sold and ending inventory. This is because you purchased the inventory at different prices. And now its quite challenging to choose the price at which you should evaluate your inventory.

Now, there are several methods that you can use to overcome this challenge. However, you should choose the one that clearly exhibits income of your business during a period. Furthermore, it is not necessary that the method you choose for valuing inventory is in line with physical movement of goods. This is because the physical flow of goods and the method of inventory valuation are quite different.  Let’s consider an example to better understand this dilemma’ .

Kapoor Mart Inc made the following transaction in its first month of operations:

Table comparing different Inventory Valuation Methods

From the above table, we can calculate:

  • cost of ending inventory of 6000 units and
  • cost of goods available for sale (beginning inventory + purchases) of Rs 43,900 (2000 units @ Rs 4.00 + 6000 units @ Rs 4.40 + 2,000 @ $4.75).

The dilemma is what price should be used to calculate the cost of ending inventory of 6,000 units.

Inventory Valuation Methods

There are various methods of inventory valuation applicable to both manufacturing and merchandising inventories. Let’s consider the Kapoor Mart example to better understand the inventory valuation methods.

1. Specific Identification Method

It is necessary to identify each item of goods sold and closing inventory in order to apply this method. Thus, special identification method is applicable only where you can physically differentiate various purchases easily.

As a result, the cost of goods sold includes the items sold at a specific cost during the accounting period . And the closing inventory includes the costs of particular items in hand or items that are left.

For example, companies selling automobiles, furniture, jewelry etc can use this valuation method successfully. This is because these companies manufacture or handle items that are expensive but are easily distinguishable.

Example

Let’s consider that Kapoor Mart Ltd has an ending inventory of 6000 units and it comprises of:

1000 units from October 8 purchase
3000 units from October 14 purchase
2000 units from October 30 purchase
Thus, ending inventory and cost of goods sold for Kapoor Mart is as follows:

Table explaining the specific identification method out of the various Inventory Valuation Methods

Cost of goods available for sale (figures taken from the above table) Rs 43,900
(-) Ending Inventory Rs 26,700

Cost of Goods Sold Rs 17,200

It was ideal for Kapoor Mart to use Specific Identification Method. This is because actual costs matched with the actual revenue. Thus closing inventory was computed at actual cost. It simply means that the cost flow matched the physical flow of goods.

However, there are certain disadvantages of using Specific Identification Method for valuing inventory.

First, it is easy for the business owner to manipulate the net income under this method. Say for instance, a wholesaler purchased same quality paper during the year at three different prices. Now, the wholesaler can manipulate the net income at the time of selling the paper. He can either choose lowest or highest price and attribute it to a particular lot of paper to be sold to the customer.

The second disadvantage of using this method is associated with arbitrary allocation of certain costs to the inventory items. For instance, discounts, shipping charges and storage costs are difficult to allocate directly to a given inventory. Therefore, in such cases the business owners are bound to allocate such costs arbitrarily. This impacts the accuracy of Specific Identification Method.

2. Average Cost Method

This method computes the average cost of items available for sale. Further, the costs of goods sold and the closing inventory is calculated using average cost of units.

Thus, companies using periodic inventory method use weighted average method to calculate the average cost. Whereas, companies maintaining inventory records using perpetual inventory method use moving average method to determine the average cost. Let’s consider the above example of Kapoor Mart to illustrate this.

Case I – Under Periodic Inventory System

Cost of Goods and Ending Inventory are calculated using Weighted Average Method for companies using Periodic Inventory Method.

Table showing Average Cost Method one of the Inventory Valuation Methods

Weighted Average Cost Per Unit = Rs 43,900/10,000 = Rs 4.39
Inventory in Units = 6000 units
Ending Inventory = 6000 * Rs 4.39 = Rs 26,340

Cost of Goods Available for Sale Rs 43,900
(-) Ending Inventory Rs 26,340
Cost of Goods Sold Rs 17,560

Case II – Perpetual Inventory System

Cost of Goods and Ending Inventory are calculated using Moving Average Method for companies using Perpetual Inventory Method.

Table showing Average Cost Method one of the Inventory Valuation Methods

As shown above, a new average per unit cost is calculated every time a purchase is made under this method. For instance, on October 14, 2018, additional 6000 units are purchased for Rs 24,600. Thus, a total of 8,000 units costing Rs 34,400 (Rs 8,000 + Rs 24,600) are available.

Therefore, the average unit cost for these 8000 units in hand is Rs 34,400/8,000 = Rs 4.30. This unit cost is used to calculate the cost of sales made till the time new inventory is purchased. That is, new average cost is calculated each time new inventory is purchased.

So, the average cost method is used widely as it is simple to use. Also, it is difficult to manipulate net income under this inventory pricing method.

3. First In First Out Method (FIFO)

The First In First Out Method assumes that the goods are consumed in the sequence in which they are purchased. That is goods purchased first are consumed first in a manufacturing concern. Similarly, goods purchased first are sold first in case of a merchandising firm.

Consequently, goods purchased recently form a part of the ending inventory under this method. Let’s consider the example of Kapoor Mart to better understand the First In First Out Method of Inventory valuation method.

Case I – Under Periodic Inventory System

FIFO method is used to determine the cost of ending inventory for companies using periodic inventory system. In this method, the cost of the latest or the most recent purchase is considered to calculate the cost of ending inventory. This means items purchased first are consumed first for manufacturing goods. Thus, items are considered backwards till the time all the items in inventory are considered. Therefore, the ending inventory is left with items priced at current or latest prices.

So, the ending inventory and cost of goods sold are calculated as follows:

First In First Out Method one of the Inventory Valuation Methods

Cost of Goods Available for Sale Rs 43,900
(-) Ending Inventory Rs 27,100
Cost of Goods Sold Rs 16,800

Case II – Perpetual Inventory System

Cost is attached to each withdrawal or sale of items under perpetual inventory system. Accordingly, goods sold on October 18, 2018 comprise of purchases made on October 8 and October 14, 2018.

First in First Out Method one of the Inventory Valuation Methods

As per the above table, sales made on October 18, 2018 using FIFO method comprise of:

  • Purchases made on October 8 (2000 units @ Rs 4.00 = Rs 8,000) and
  • Purchases made on October 14 (6000 units @ Rs 4.40 = Rs 26,400)

Thus, the ending inventory  is Rs 27,100 and the cost of goods sold is Rs 16,800 as per this method.

There are various advantages using FIFO method. First, it does not allow any manipulation of income. This is because business cannot choose certain cost item and take it as an expense. In other words, items purchased first need to be charged first.

Secondly, the ending inventory is taken at the most recent cost. Thus, FIFO method provides a close approximation of the replacement cost on balance sheet. It is because the ending inventory is made up of the most recent purchases. This happens in cases when there are no price changes from the time latest purchases are made.

However, the disadvantage of using FIFO method is that there is a mismatch between current costs and current revenues. It is because oldest costs are matched with current revenues.  This can lead to misleading profit figures.

4. Last In First Out Method (LIFO)

LIFO Method assumes that recent goods purchased are consumed first and the goods purchased first are consumed later. Thus, cost of goods sold is calculated using the most recent purchases. Whereas the ending inventory is costed using the cost of the oldest units available.

Case I – Under Periodic Inventory System

The total quantity of sales made during a month come from the latest purchases if a company uses periodic inventory system.

Table showing Last in First Out Method one of the Inventory Valuation Methods

Goods Available For Sale Rs 43,900
(-) Ending Inventory Rs 25,600
Cost of Goods Sold Rs 18,300

Hence, as per the above table, 4000 units sold on October 14, 2018 would comprise of:

2000 units purchased on October 30, 2018 and
2000 units out of 6000 units purchased on October 14, 2018

Case II – Perpetual Inventory System

Companies will have different ending inventory and cost of goods sold if they use

  • perpetual inventory system for recording inventory and
  • LIFO method for inventory valuation
Table showing LIFO Method one of the Inventory Valuation Methods

As per the above table, sales made on October 18, 2018 using LIFO method comprise of:

Purchases made on October 14 (4000 units @ Rs 4.40 = Rs 17,600)

Thus, the ending inventory is Rs 23,600 and the cost of goods sold is Rs 17,600 according to this method.

So there are various advantages of using LIFO method. First, it matches the most recent costs with the current revenues giving a better measure of profitability. Further LIFO method offers tax benefits to the business. This is because items recently purchased at higher price levels lead to increasing the cost of goods sold and reducing the net income. Thus, reduced net income means reduced taxes for the business.

However, the disadvantage of using LIFO method is that it gives way to lower profits for the business in inflationary times. Reduced earnings further may be misinterpreted by the investors thereby reducing the company’s stock price. Further, the ending inventory in the balance sheet recorded at oldest costs understates the working capital position of the company.

You May Also Read

FIFO vs LIFO: All You Need To Know

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Related Articles

What is Inventory in Accounting?

What is Inventory? Inventory is an asset that is: Held for sale…

Read more

FIFO Vs LIFO: All You Need To Know

Inventories are one of the largest and critical components appearing in the…

Read more

Small Business Term: What Is Cash Conversion Cycle

Cash Conversion Cycle (CCC) is the time period that your business takes…

Read more