Valuation of Inventory:
Based on Historical Cost:
Valuation of inventory is made on a conservative basis, i.e., expected profits are not to be considered whereas possible losses are to be provided for. As such, it is valued at the lowest of:
(i) Historical cost;
(ii) Net realisable value, and
(iii) Replacement price/value. The term ‘cost’ usually refers to designate the historical cost, i.e., outlay of cash or its equivalent in the acquisition of particular item of inventory. In other words, it is the sum total of the price paid along with all expenditures and charges directly or indirectly incurred in bringing inventory to its existing condition and location.
Therefore, in case of materials and supplies, the price paid including freight and carriage represents their cost and sometimes a part of the storage expenditure is also included. In case of work-in-progress, however, cost represents sum total of direct material cost, direct wages and direct expenses including manufacturing and factory overhead.
The elements making up cost of finished goods or stock-in-trade are incurred in bringing:
(i) The purchase price of goods, stores, and, in case of processed stock, materials used in manufacture,
(ii) All direct expenditures (e.g. direct wages, cost of tools, design etc.) incurred in bringing stock-in-trade to its existing condition and location; and
(iii) Indirect or overhead expenditure incidental to the class of stock-in-trade concerned.
As the production and sales cycle is a continuous and repetitive process, costs which are incurred during an accounting period at different times in order to bring an article to its existing condition and location, varies due to certain factors, viz., the seasonal effects, the efficiency of the workers, the attitude of management etc. This variation, no doubt, creates the difficulty of identification of cost of inventories for the purpose of their valuation. Of course, they said difficulties may be overcome by certain arbitrary assumptions and, as such, different bases are generally adopted.
Pricing the Issues of Materials:
When materials are issued they should be priced by the cost department. Such materials are recorded in the store ledger and charged to a job.
Various methods of pricing materials are presented:
1. Cost Method:
(a) Cost method as per the principles of:
i. First-in-First out (FIFO) basis;
ii. Last-in-First out (LIFO) basis;
iii. Base Stock;
iv. Highest-in-First out basis;
v. Next-in-First out basis
(b) Average Cost Method:
i. Simple Average Method;
ii. Weighted Average Method;
iii. Periodic Average Method;
iv. Moving Average Method
2. Standard Price Method:
3. Specific Cost Method
4. Replacement Price Method or Market Price Method
5. Inflated Price Method, and
6. Reverse Price Method
Some of the important methods are explained below with the help of suitable illustrations:
Under this method, materials which are received first are also issued first. In other words, the pricing of the issue of the first lot is done at the cost at which that lot was acquired. As such, the closing inventories are valued at latest purchase price and, thus, it will represent current condition as far as possible.
That is, closing inventories are always out of the latest lots acquired or purchased or manufactured. The same leads to represent replacement price. This method is particularly applicable where price does not fluctuate very frequently and the materials are not fast moving.
Under this method, it is assumed that the materials purchased are issued in the reverse order to FIFO, i.e., the last receipt is the first issue or the latest lots of inventories are exhausted first. In short, inventories are valued at earlier purchase prices.
Average Cost Method:
Under this method, all items in the stores are mixed up in such a way that consumption of materials or sale of finished goods cannot be recognised from any particular lot of purchases. As a result, closing inventories are valued at the average cost of all the lots acquired under each type during a particular period.
The average cost may be:
(i) Simple Average Cost; and
(ii) Weighted Average Cost
(i) Simple Average Cost:
Under this method, average of different prices are only considered without having regard to the quantities involved. The simple average cost is calculated by adding the different prices and, thereafter, divided by the total number of purchases. This method is applicable where there is wide fluctuation in prices.
(ii) Weighted Average Method:
Under this method, rate of average cost is calculated by taking into consideration both the prices and quantities acquired at such prices, i.e., the total value of materials in stock at the time of issue divided by the total quantity of materials in stock in order to find out the weighted average rate. It is superior than the ordinary Simple Average Method since it takes into account both the prices and the quantities.
This method proves very useful where there is a heavy fluctuation in the prices of inventories as it tends to smooth out fluctuations in prices by taking the average cost of different lots acquired at different times. But, under this method, cost of goods sold does not represent the actual cost.
Base Stock Method:
Under this method, it is assumed that every firm has to maintain a certain minimum amount of inventory (in the form of raw materials, work-in-progress and finished goods) throughout the year. The same will have to be maintained for meeting emergency needs, such as undue delay in supply of raw materials, excessive consumption etc.
This minimum level of inventory goes by the name of Base Stock or Safety Stock. ‘Base-Stock’ serves as the signal below which the inventory level of a firm is never allowed to fall. (Therefore inventory, to the extent of ‘Base-Stock’, though basically a class falling within the category of current assets, assumes, for all practical purposes, the character of fixed assets.)
Generally, there may not be any wide variation between the volume of closing and opening inventory unless there is a remarkable change in the scale of operation and other factors. The ‘Base- Stock’ level is usually created out of the first lot of the materials purchased or goods manufactured at the beginning of the period and, as such, it is valued at the cost price of the first lot.
Therefore, under this method, closing inventories are generally taken to be equal to the ‘Base-Stock’ level and, hence, they are valued at the values allotted to the respective ‘Base-Stock’. However, if there is any excess (over base stock level) the same should be valued either on the basis of FIFO or LIFO methods.
It should be remembered that this method is generally used with FIFO or LIFO method. There is, however, difference of opinion among the accountants as to the principles to be followed for valuation of inventories when this method is adopted.
For example, Finney and Miller suggest that ‘Base Stock’ may be valued at lowest cost experienced and valuation of closing inventory (when it goes below base stock) ‘should be made by deducting the value of the deficient quantity calculated at the current cost from the value of the normal quantity of base stock calculate at the base price’.
Further, Yorston, Smyth and Brown suggest that ‘the difference between the replacement price and the fixed price of the basic stock is deducted from the total value of the stock on hand computed at the basic price.’ This method usually is operated either in conjunction with FIFO or LIFO method. It may be observed that the objective of pricing inventories on the basis of this method is to apply the current prices to issue. So, this objective will be fulfilled only when LIFO method is adopted as a method of combination.
1. This method is simple to understand and easy to operate.
2. This technique serves the valuation of closing stock easily.
3. This method practically renders the profit and loss most conservative.
4. It is particularly applicable where a certain quantity of basic materials is needed in process for a long time.
5. All the advantages of FIFO and LIFO method will also be applicable in this method.
1. The disadvantages appearing in FIFO or LIFO may also apply in this method.
2. Sometimes ‘Base-Stock’ may appear in Balance Sheet at most unreliable price and, as such, the owners/shareholders may be cheated.
3. Since ‘Base-Stock’ is a part of stock of materials (i.e., a part of current assets) can it be treated as a fixed asset which appears at cost in the Balance Sheet?
Specific Identification Cost/Unit Cost or Actual Cost:
This method of valuation is adopted where each item of inventories and its actual cost is identifiable. It attributes certain specific costs to the identified items of inventory where each such item and its cost is identifiable. That is, this method of valuation can easily be applied where the closing inventory items can correctly be identified with specific lots.
But this method suffers from the following limitations:
1. Where there is bulk quantities of inventories, partly finished goods or finished goods, and where individual units of inventories lose their identity.
2. Where there is innumerable units of inventories, keeping records for each of them becomes expensive as well as time-consuming.
Other Method of Valuation of Inventory — Other than those based on Historical Cost:
Some of the important methods of valuation of inventory (other than those based on historical cost) are noted below:
(a) Standard Cost Method;
(b) Inflated Cost Method;
(c) Reverse Cost Method;
(d) Replacement Cost Method, and
(e) Realisable Market Value Method.
(a) Standard Cost:
Under this method, closing inventories are valued at pre-fixed standard rates. This method is found suitable where the manufacturing units are engaged in production on a large scale. But this method cannot reveal the true value of inventory when production is completed after passing through several processes or where manufactured products are of different varieties.
At the same time, if there is a slight error in fixing the single standard rate the same will affect the measure of all items of inventory.
(b) Inflated Cost Method:
Under this method, closing inventories are valued at a cost per unit which is higher than the actual cost per unit to provide for the normal loss due to certain defects inherent in them, e.g. loss due to evaporation, shrinkage etc.
(c) Reverse Cost Method:
Under this method, inventories are valued at an estimated cost which is determined by deducting an amount equivalent to the normal profit margin and the estimated cost disposal from the current selling prices. This method is also referred to as ‘Adjusted Selling Price.
(d) Replacement Cost Method:
Under this method, each closing item of inventory is valued at cost which is to be incurred for purchasing/procuring the said item from the open market on the date of valuation, i.e., they are valued at the replacement cost as on that date. This cost of replacement should be determined in relation on the current market price of similar items.
(e) Realisable Market Value:
Under this method, each closing item of inventory is valued at its estimated net realisable value. The net realisable value —i.e., prospective selling price less all prospective costs to be incurred in conditioning and selling the goods, may be adopted suitably for the purpose of valuation.