Inventory Valuation

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 Determine the Op. Income Value the cost of goods held on he balance sheet.

2. The objective of inventory valuation is to:

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 July 10 July 15 July 27 Available For sale 10 Tyres @ Rs. 120 20 Tyres @ Rs. 130 15 Tyres @ Rs. 140 5 Tyres @ Rs. 150 50 Tyres 8 Tyres 58 Tyres Closing Inventory Sold 20 Tyres 38 Tyres Rs. 1200 Rs. 2600 Rs. 2100 Rs. 750 Rs. 7,450

Inventory Valuation Methods -Specific Identification
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 Inventory 12 x 130 8 x 140 = Rs. 1,560 = 1,120 Rs. 2,680 Rs. 2,680

Average Cost Method
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

Last In, First Out 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 July 3 July 10 Closing Inventory = = = 8 x 100 10 x 120 2 x 130 = = = Rs. 800 Rs. 1,200 Rs. 260 Rs. 2,260 Rs. 2,260 8 Tyres 10 Tyres 2 Tyres

First 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 Higher Unsold July 15 July 27 Closing Inventory = = 15 x 140 5 x 150 = = Rs. 2,100 Rs. 750 Rs. 2,850 Rs. 2,850 Tax Overstated Liability 15 Tyres 5 Tyres

This 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.

It is subject to the following criticisms; a) It is purely a tax-saving device and not a method of recording costexpiration. 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

Value of goods available for sale Less Closing Inventory Cost of Goods Sold

Rs. 7,450












Comparative Profit Schedule
Assume Sale of 38 tyres @ Rs. 200 each Spl. Ident. Av. Cost FIFO LIFO

Sales Cost of Goods Sold Profit

Rs. 7,600












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.

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