Determining the monetary amount of Inventory at any given point in time

Introduction: Accounting for Inventory: There are 3 types of companies for which inventory accounting is very necessary. 1) Merchandising company:- Retail shops, wholesalers, distributor and similar companies that sell tangible goods. 2) Manufacturing company:- A company that converts raw materials in to finish goods. 3) Service organization:- A company that serves intangible goods.

Manufacturing company:It has 3 types of inventory accounts:1) Materials Inventory:-

Inventory costing methods: There are 4 types of inventory costing methods:-

Specific identification 2. Average cost 3. First In, First Out (FIFO) 4. Last In, First Out (LIFO)
1.

Specific Identification Method:-

Average cost
In this method inventories are issued at average price.
Inventories are charged at the price which falls

between FIFO and LIFO. Thus, Average Cost method is moderates, the FIFO and LIFO prices.

Average cost
Example:1st April Opening stock- 100 kg @ Rs.10 5th April purchases- 200 kg @ Rs. 11 10th April purchases- 80 kg @ Rs. 11.50 14th April Issued to A Department- 120 kg 21st April purchases 150 kg @ RS. 12 28th April issued to B department 230 kg

FIFO illustration:Date Receipts Qty Ap. 1 5 100 200 Rate 10 11 Amt 1000 2200 Issues Qty Rate Amt Balance Qty 100 100 200 Rate 10 10 11 Amt 1000 1000 2200

10

80

11.50

920

100 200 80
100 20 10 11 1000 220 180 80 180 80 150 180 50 11 11.50 1980 575 30 150

10 11 11.50
11 11.50 11 11.50 12 11.50 12

1000 2200 920

1980 920 1980 920 1800 345 1800

14 21 150 12 1800

28

FIFO Method: In this method the materials which are purchased first will issued first.
Materials are issued at the oldest consignment

prices till it is exhausted. Then after, materials are issued at next consignment price and so on.

LIFO Method: This method is totally reverse form FIFO.

In this method materials are issued at last consignment prices.

Then after, materials are issued at immediately preceding consignment price and so on.

LIFO illustration:Date Receipts Qty Ap. 1 5 10 100 200 80 Rate 10 11 11.50 Amt 1000 2200 920 Issues Qty Rate Amt Balance Qty 100 100 200 100 200 80 80 40 150 12 1800 11.50 11 920 440 100 160 100 160 150 150 80 12 11 1800 880 100 80 Rate 10 10 11 10 11 11.50 10 11 10 11 12 10 11 Amt 1000 1000 2200 1000 2200 920 1000 1760 1000 1760 1800 1000 880

14 21

22

Average cost method:Date Receipts Qty Ap. 1 5 10 100 200 80 Rate 10 11 11.50 Amt 1000 2200 920 Issues Qty Rate Amt Balance Qty 100 300 380 Rate 10 10.67 10.84 Amt 1000 3200 4120

14 21 150 12 1800

120

10.84

1300

260 410

10.84 11.27

2820 4620

22

230

11.27

2592

180

11.27

2028

 By definition, inventory is the term used to describe the

assets of a company that are intended for sale in the ordinary course of business, are in the process of being produced for sale, or are to be used currently in producing goods to be sold. Inventory in a business is a list of goods or products that is held in stock. It takes a lot of time to keep inventory, but failure to do so could result in major financial disasters. Depending on the size of your business, there are people whose sole job is to keep track of inventory. In a small business, this would not have to be their only task.

Treatment in Financial Statement

Inventory is converted into cash within the companys operating

cycle and, therefore, is regarded as a current asset. In the balance sheet, inventory is listed immediately after Accounts Receivable, because it is just one step farther removed from conversion into cash than customer receivables. Being an asset, it is shown in the

balance sheet at its cost. As items are sold from this inventory,
their costs are transferred into cost of goods sold, which is offset against sales revenue in the income statement.

Treatment in Financial Statement

Having no inventory or having wrong inventory can lead to

many problems. Because inventory is reflected in the companys books, a business owner may make decisions

based on the inventory numbers he sees in the books. If the

number is wrong, he just made a wrong decision that could be costly. In order to prevent this from happening in your business, there are ways to keep proper inventory that any sized business can use.

Classifying Inventories:
Inventories can be classified according to type of

business: Merchandise Inventory Manufacturing Inventory

Merchandise Inventory
Merchandise available of hand and available for sale to

customers. For e.g.: canned foods, meats, dairy products etc. Items in the merchandise inventory have two common characteristics: a: they are owned by the company b: they are in the form ready for sale to customers in the ordinary course of business. Inventory sold becomes the cost of merchandise sold. It is the ready-to-sell inventory of merchandising firms.

Manufacturing Inventory
Merchandise that needs to be produced in order to sell is called manufacturing inventory. Although products may differ, manufacturers normally have three inventory accounts, each of which is associated with a stage of the production process: raw materials inventory, work-in-process inventory, finished goods inventory.

(a) Raw Materials Inventory

It consists of goods and materials that ultimately will
become part of the manufactured product but have not yet entered the production process. For example, the raw materials of an automobile manufacturer generally include sheet metal, nuts, bolts, and paint.

(b) Work-In- Process Inventory

It consists of units in the production process that require
additional work or processing before becoming finished goods.

(c) Finished Goods Inventory

It consists of units that have been completed and are

available for sale at the end of the accounting period.

INVENTORY VALUATION
Goods sold (or used) during ac accounting period seldom correspond

exactly to the goods bought (or produced) during that period. As a result, inventories either increase or decrease during the period. Companies must then allocate the cost of all the goods available for sale

(or used) between the goods that were sold or used and those that are
still on hand. The cost of goods available for sale or use is a sum of

The cost of goods on hand at the beginning of the period. The cost of goods acquired of produced during the period.

INVENTORY VALUATION
The cost of goods sold is the difference between the cost of goods available for

sale during the period and the cost of goods on hand at the end of the period.
Valuing inventories can be complex. It requires determining the following: The physical goods to include in inventory (who owns the goods goods in the

transit, consign goods, special sales agreements).

The cost to include in inventory (product vs. period cost) The cost flow assumptions to adopt (specific identification, average cost, FIFO,

LIFO, retail, etc.)

INVERTORY VALUATION METHODS

There are three methods of valuation of inventories

under the accounting systems based on the type and nature of products.
First-In-First Out (FIFO) Last-In-First Out (LIFO) Average Cost Method (AVCO)

FIRST-IN-FIRST OUT METHOD (FIFO)

The FIFO method assumes that a company uses the

goods in the order in which it purchases them. In other words, the FIFO method assumes that the first goods purchased are the first used (manufacturing concern), or the first sold (in a merchandising

concern). The inventory remaining must therefore

represent the most recent purchases.

FIRST-IN-FIRST OUT METHOD (FIFO)

FIFO often parallels the actual physical flow of merchandise

because it generally is good business practice to sell the oldest units first. That is, under FIFO, companies obtain the cost of

ending inventory by taking the unit cost of the most recent

purchase and working backwards until all units of inventory have been costed. This is true whether a company computes cost

of goods sold as it sells goods throughout the accounting period

(perpetual system) or as a residual at the end of the accounting period (periodic system).

FIFO illustration:Date Receipts Qty Ap. 1 5 100 200 Rate 10 11 Amt 1000 2200 Issues Qty Rate Amt Balance Qty 100 100 200 Rate 10 10 11 Amt 1000 1000 2200

10

80

11.50

920

100 200 80
100 20 10 11 1000 220 180 80 180 80 150 180 50 11 11.50 1980 575 30 150

10 11 11.50
11 11.50 11 11.50 12 11.50 12

1000 2200 920

1980 920 1980 920 1800 345 1800

14 21 150 12 1800

28

LAST-IN-FIRST OUT METHOD (LIFO)

The LIFO method assumes the cost of the total quantity sold or

issued during the month comes from the most recent purchases. That is, the latest goods purchased are the first to be sold. LIFO

coincides with the actual physical flow of inventory. The method

matches the cost of the last goods purchased against revenue. Under the LIFO method, the costs of the latest goods purchased

are the first to be recognized in determining the cost of goods

sold. The ending inventory is based on the prices of the oldest units purchased.

LAST-IN-FIRST OUT METHOD (LIFO)

Companies obtain the cost of the ending inventory by

taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed.

LIFO illustration:Date Receipts Qty Ap. 1 5 10 100 200 80 Rate 10 11 11.50 Amt 1000 2200 920 Issues Qty Rate Amt Balance Qty 100 100 200 100 200 80 80 40 150 12 1800 11.50 11 920 440 100 160 100 160 150 150 80 12 11 1800 880 100 80 Rate 10 10 11 10 11 11.50 10 11 10 11 12 10 11 Amt 1000 1000 2200 1000 2200 920 1000 1760 1000 1760 1800 1000 880

14 21

22

AVERAGE COST METHOD (AVCO)

Under the average cost method, the costs of goods are equally divided,

or averaged, among the units of inventory. It is also called the weighted average method. When this method is used, costs are matched against revenue according to an average of the unit of cost of goods sold.
The same weighted average unit costs are used in determining the cost

of the merchandise inventory at the end of the period. For businesses in which merchandise sales may be made up of various purchases of

identical units, the average method approximates the physical flow of

goods.

AVERAGE COST METHOD (AVCO)

This method is determined by dividing the total cost

of the units of each item available for sale during the period by the related number of units of that item.

Average cost method:Date Receipts Qty Ap. 1 5 10 100 200 80 Rate 10 11 11.50 Amt 1000 2200 920 Issues Qty Rate Amt Balance Qty 100 300 380 Rate 10 10.67 10.84 Amt 1000 3200 4120

14 21 150 12 1800

120

10.84

1300

260 410

10.84 11.27

2820 4620

22

230

11.27

2592

180

11.27

2028

COMPARISON BETWEEN THE METHODS OF INVENTORY VALUATION

EFFECT OF THE VALUATION METHODS ON FINANCIAL STATEMENT

Since prices keep on changing, the three methods yield

different amounts for (1) the cost of merchandise sold for the period (2) the gross profit (net income) for the period (3) the ending inventory. There is also a tax effect that varies with changes in net income among

different valuation methods.

(a) Income Statement

FIFO: FIFO gives the highest amount of gross profit

(hence, net income) because the lower unit costs of the first units purchased are matched against revenues, especially in times of inflation. However in times of falling prices, FIFO will report lowest inventory. It also yields the highest amount of ending inventory and the lowest cost of goods sold. This will give a false impression of paper profit.

(a) Income Statement

LIFO: LIFO gives the lowest amount of net income during

inflationary times and the highest net income during price declines. It gives the lowest amount of ending inventory

and the highest cost of goods sold.

AVCO: Average Costs approach tends to produce cost of

goods sold and ending inventory results between the results by LIFO and FIFO.

(a) Income Statement

To the management, higher net income is an

advantage: it causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Hence during inflationary times, companies prefer using FIFO.

(b) Balance Sheet

FIFO: During periods of inflation, the costs allocated

to ending inventory will approximate their current cost. In fact, the balance sheet will report the ending merchandise inventory at an amount that is about the same as its current replacement costs. As inventories

are overstated in FIFO, this will affect the total assets

and hence the stockholders equity, overstating it.

(b) Balance Sheet

LIFO: In a period of inflation, the costs allocated to ending

inventory may be significantly understated in terms of current costs. This is because more recent costs are higher than the earlier unit costs. Thus it matches current costs nearly with current revenues. (Warren & Reeve, 2004)In LIFO, inventories are understated. This, in turn, affects the stockholders equity by understating the actual figures.

(b) Balance Sheet

AVCO: Average cost approach for series of purchases

will be same, regardless of direction of price trends. In its effect on the balance sheet, however, it is more like FIFO than LIFO.

FIFO

LIFO

Average Cost