4. TECHNIQUES OF INVENTORY VALUATION
4.1 HISTORICAL COST METHODS
Under historical cost methods, cost of goods refers to the historical cost of acquisition of goods. It is the value of resources required to obtain the inventory in its present condition and includes “cost of purchase and other costs incurred in bringing the inventories up to their present location and condition”.
The purchase price including duties and taxes (other than those which are subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition of goods. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.
Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. While determining cost of inventories, certain costs are excluded and recognised as expenses in the period in which they are incurred. Examples are: (i) costs arising due to abnormal amount of wasted materials, labour or other production costs, and (ii) storage costs are excluded in calculation of cost of inventories unless these costs are necessary in the production process prior to a further production stage, (iii) administrative overheads that do not contribute to bring the inventories to their present location and condition; and (iv) selling and distribution costs. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories.
There is no unique formula for determination of historical cost of inventories. The different techniques for valuation of inventory have been discussed below:
(i) Specific Identification Method
Pricing under this method is based on actual physical flow of goods. It attributes specific costs to identified goods and requires keeping different lots purchased separately to identify the lot out of which units in inventories are left. The historical costs of such specific purpose inventories may be determined on the basis of their specific purchase price or production cost.
This method is generally used to ascertain the cost of inventories of items that are not ordinarily interchangeable, otherwise it requires the use of FIFO (First in first out) or weighted overage price/average price formula.
(ii) FIFO (First in first out) Method
The actual issue of goods is usually from the earliest lot on hand. The inventory of goods on hand therefore, consists of the latest consignments. Thus, the closing inventory is valued at the price paid for such consignments.
Now, let us take an example to understand the application of FIFO method.
A manufacturer has the following record of purchases of a condenser, which he uses while manufacturing radio sets:
|Date||Quantity (units)||Price per unit|
1,600 units were issued during the month of December.
The closing inventory is 1,000 units and would consist of -
800 units received on 28th December; and
200 units received on 19th December as per FIFO
The value of 800 units @ Rs 4.75 3,800
The value of 200 units @ Rs 6.00 1,200
(iii) LIFO(Last in first out) Method
Though actual issues are made out of the earliest lot on hand to prevent unnecessary deterioration in value, it is sometimes assumed that the issue to be valued is to be according to the price paid for the latest consignments on hand. The closing inventory then is assumed to consist of earlier consignments and its value is then calculated according to such consignments. This method of valuing inventories is known as LIFO basis. Under this basis, goods issued are valued at the price paid for the latest lot of goods on hand which means inventory of goods in hand is valued at price paid for the earlier lot of goods. In the absence of details of issue, the price paid for the earliest consignments is used for valuing closing inventory.
LIFO method is based on an irrational assumption that inventories entering last in the stores are issued or consumed first. However, the flow of goods which is generally observed in business entities is contradictory to this assumption. Therefore, LIFO method is no longer adopted for valuing inventories. Generally, in practice, FIFO and Average Price Method are popular among the business entities.
(iv) Average Price Method
Average price for computing value of inventory is a very simple approach. (All the different prices are added together and then divided by the number of prices). The closing inventory is then valued according to the price ascertained.
In the same example of a manufacturer of radio sets given earlier, let us calculate the value of closing inventory using Average Price Method:
Record of purchases
|Date||Quantity (units)||Price per unit|
Record of issues
The simple average in this question is:
[(5.00 + 5.50 + 5.50 + 6.00 + 4.75)/5] = 26.75/5 = Rs 5.35
1,000 units valued at Rs 5.35 would be Rs 5,350.
Let us try to analyse the impact of FIFO and Average price method with the help of the following chart:
(v) Weighted Average Price Method
However, it is more logical to compute weighted average price using the quantities purchased in a lot as weights. Under weighted average price method, cost of goods available for sale during the period is aggregated and then divided by number of units available for sale during the period to calculate weighted average price per unit. Thus
Closing inventory = No. of units in inventory X Weighted average price per unit
Cost of goods sold = No. of units sold X Weighted average price per unit.
On the basis of the data given in illustration 1, calculate the weighted average price and also the value of closing inventory by weighted average price method.
Solution The computation of weighted average price in the referred example is shown below:
Weighted average price = Rs 13,350/2,600
= Rs 5.135 per unit
Value of closing inventory of 1,000 units = 1,000 x Rs 5.135 = Rs 5,135
It should be noted that if a inventory ledger is maintained, recording receipts/issues daily, the average would be different. A new average rate would be calculated on receiving a fresh consignment. Answer on that basis would be as under:
Date Receipts issues Balance
4.2 NON-HISTORICAL COST METHODS
Non-historical cost methods do not consider the historical cost incurred to acquire the goods. Non- historical cost methods include Adjusted Selling Price method, Standard Cost and Latest Purchase Price method. Adjusted Selling Price method can be explained as follows:
(i) Adjusted selling price method
This method is also called retail inventory method. It is used widely in retail business or in business where the inventory comprises of items, the individual costs of which are not readily ascertainable. The use of this method is appropriate for measuring inventories of large numbers of rapidly changing items that have similar margins and for which it is impracticable to use other costing methods. The cost of the inventory is determined by reducing from the sales value of the inventory the appropriate percentage of gross margin. The percentage used takes into consideration inventory which has been marked below its original selling price. An average percentage for each retail department is often used. The calculation of the estimated gross margin of profit may be made for individual items or groups of items or by departments, as may be appropriate to the circumstances.
M/s X, Y and Z are in retail business, following information are obtained from their records for the year ended 31st March, 2011:
Goods received from suppliers
(subject to trade discount and taxes) Rs 15,75,500
Trade discount 3% and sales tax 11%
Packaging and transportation charges Rs 87,500
Sales during the year Rs 22,45,500
Sales price of closing inventories Rs 2,35,000
Find out the historical cost of inventories using adjusted selling price method.
Determination of cost of purchases:
Goods received from suppliers
Less : Trade discount 3%
Add: Sales Tax 11%
Add: Packaging and transportation charges
Determination of estimated gross profit margin:
Sales during the year
Closing inventory at the selling price
Gross profit margin
Selling price of closing inventories
Less : Gross profit margin 28.09%
From the following information, calculate the historical cost of inventories using adjusted selling price method:
|Sales during the year||2,00,000|
|Cost of purchases||2,00,000|
|Closing inventory at selling price||50,000|
Calculation of gross margin of profit:
|Add: Closing inventory (at selling price)||50,000|
|Selling price of goods available for sale :||2,50,000|
|Less : Cost of goods available for sale||2,00,000|
Rate of gross margin
Cost of closing inventory = 50,000 less 20% of Rs 50,000 = Rs 40,000