Finance

Inventory Valuation System

Inventory Valuation System

In general, the inventory refers to the goods of the company at three stages of production: 1) Goods which are raw materials, 2) Goods which are being produced, and 3) Goods which are completed and ready for sale. In other terms, you take the products that the company has at the start, add the supplies that it has bought to produce more goods, deduct the goods that the company has sold, the expense of the goods sold (COGS), and, as a result, what remains — an inventory.

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​BI+ Net Purchases −COGS=EI

where:

BI = Beginning inventory & EI = Ending Inventory​

What is Inventory Valuation System and Why is it Important? 

Inventory valuation is the sum of money associated with the items in the inventory at the end of the accounting period. There are periods that you buy inventory at various rates in a given accounting cycle. In such scenarios, it becomes challenging to determine the cost of goods sold and ending inventory since inventory is purchased at different prices. It becomes quite challenging to choose the price at which inventory would be evaluated. Inventory valuation methods come to rescue under such situations. Depending on the nature of the business and other requirements different valuation methods are preferred. Inventory valuation methodologies are used to measure the cost of goods sold and the cost of the final inventory. Following are the three primarily used inventory valuation methods:

inv

FIFO- First In First Out

The First In First Out Method assumes that the goods are consumed in the sequence in which they are purchased i.e. goods purchased first are consumed first. The pricing of the first lot issue is carried out at the price at which that lot was obtained. As such, the closing inventories, priced at the latest purchase price, would, as far as possible, reflect the current situation. This method ensures correct valuation on closing inventory at the latest available market price. Also, this is the most widely used method for inventory valuation. The FIFO method is similar to the actual physical movement of goods since firms generally sell goods in order in which they are bought or manufactured.

For example, you may be a retailer of clothes. In January 2020, you order 40 pants of a specific type for $100 each from your vendor. In February, order the same 40 pants but at $150 each. So, if you sell 30 shirts, the cost of goods in this method would be $3000.

Cost of Goods Sold = Quantity (30) X FIFO cost ($100) = $3000

In addition to the above closing Inventory would be as follows:

Closing Inventory = Quantity (10) x FIFO cost ($100) + Quantity (40) x FIFO Cost ($150) = $7000

LIFO – Last In First Out

The Last-In, First-Out (LIFO) method assumes that the last or more unit to arrive in inventory is sold first. This inventory valuation method is precisely the opposite of the first-in-first-out method. Here, it is presumed that newer inventory is first sold and older stays in inventory. When prices of goods increase which is generally the case unless the economy is in recession, the cost of goods sold in the LIFO method is relatively higher, and the ending inventory balance is relatively lower. LIFO is further divided as follows:

inv1

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Under Periodic Inventory System

Periodic inventory is an accounting stock valuation practice that’s carried out at specified intervals. In this inventory system, a form of inventory valuation exists where the inventory account is updated at the end of an accounting period rather than after every sale and purchase. The method allows a business to monitor its beginning inventory and ending inventory during an accounting period. This type of inventory system is easier to calculate and is ideal for small businesses.

Under Perpetual Inventory System

On the other hand, the perpetual system maintains track of inventory balances on an ongoing basis, with changes made automatically whenever a product is received or sold. Purchases and returns are immediately recorded in the inventory account. The cost of goods sold on the account is often updated on an ongoing basis when each sale is made. Perpetual inventory systems are using digital technologies to monitor inventory in real-time using updates sent electronically to central databases. This system is ideal for large scale business with a continuous flow of inventory either way.

Example:

Formula Used:

Number of units sold during the year = Beginning inventory + Units purchased during the year – Ending inventory

A trading company has provided the following data about purchases and sales of a commodity made during the year 2020.

  • Jan. 01: Beginning inventory; 1,000 units @ $16 per unit.
  • Feb. 15: Purchased; 1,800 units @ $18 per unit.
  • Apr. 15: Purchased; 1,000 units @ $20 per unit.
  • Jul. 10: Purchased; 2,000 units @ $22 per unit.
  • Oct. 20: Purchased; 1,500 units @ $24 per unit

According to a count, 1,300 units were found in inventory on December 31, 2020. The company uses a system of periodic inventory to account for sales and inventory purchases.

Beginning Inventory: 1000 @ 16 16000

Add Purchases:

1800 @ 18 32400
1000 @ 20 20000
2000 @ 22 44000
1500 @ 24 36000
Total Inventory: 132400
Less: Cost of ending units              (1000 @ 16 + 300 @ 18) 21400
COGS 127000

 

WA – Weighted Average Method

The weighted-average method of inventory valuation follows a system of averaging costs of all the inventory and dispatching them based on a mean cost. While using the weighted average method, divide the cost of the goods available for sale by the number of units available for sale, which results in the weighted average cost per unit. In this calculation, the cost of goods available for sale is the sum of beginning inventory and net purchases. You then use this weighted-average computation to assign both the end of the inventory and the cost of the goods sold. The net result of using weighted average costing is that the recorded amount of inventory on hand represents a value somewhere between the oldest and newest units purchased into stock. Similarly, the cost of goods sold would represent the cost between the oldest and newest units sold over the period.

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Conclusion:

  • Inventory valuation is necessary to arrive at profits in order to compute the cost of inputs, there are three widely used inventory valuation methods.
  • FIFO method is acceptable in both US GAAP and IFRS. This method assumes the inventory that comes first if first to be dispatched as a finished product in sales.
  • LIFO is acceptable only under US GAAP, and is based on the notion inventory to enter last is first to be dispatched as a finished product.
  • Weighted average averages out cost across the inventory available.

 

Author: Varsha Bhambhani

About Author: I’m an FRM professional and CFAL-2 candidate with 3 yrs of work ex in the risk domain. My interest includes mathematics and finance. From a personal life perspective, I love health and fitness, in not studying one can find me inside the gym aka nerd gym rat.

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