Unit 9: Inventory Valuation

I. Orientation: Inventory and the Costing of Material Issues

Inventory valuation is the process of assigning a monetary value to the stock of materials a business holds and to the materials it issues to production or sale during a period. Because identical units of material are often bought at different prices over time, a costing convention is needed to decide which cost attaches to each issue and which remains in closing stock. The choice directly affects the cost of goods sold, reported profit, and the balance-sheet value of closing inventory.

• Objective: to charge issues and value closing stock in a consistent, defensible way so that profit and asset value are neither overstated nor understated.
• Core identity: every method obeys the flow of value:
  
  TEXT

    Opening stock value + Purchases value = Issues value + Closing stock value

  
  What differs between methods is only how the total is split between "issues" and "closing stock".
• Physical flow vs cost flow: the actual movement of goods (FIFO in a perishables store) need not match the cost-flow assumption chosen; the two are independent decisions.
• Perpetual (continuous) system: stock ledger updated after every receipt and issue, so an issue is priced from the balance on hand at that moment.
• Consistency convention: once a method is adopted it should be applied period after period, so that reported trends reflect real change, not a change of technique.
• Key variables used throughout:
  • Receipt: units bought and their unit cost.
  • Issue: units sent out, priced by the chosen rule.
  • Balance: running quantity and value left in store.

II. Methods of Pricing Material Issues

The family of cost-flow conventions and how they are grouped

A. Purpose and Principle

A pricing method converts the physical quantity of each material issue into a cost, using a rule about which purchase lots are deemed to leave the store first.

• Why several methods exist: prices change, so the same physical issue can carry different costs depending on which lot it is drawn from; different rules serve different reporting goals.
• What a good method balances:
  • Realistic issue cost: the charge to production should reflect current replacement conditions where possible.
  • Realistic stock value: closing stock on the balance sheet should not be badly out of date.
  • Practicality: the method must be workable in a store ledger without excessive recalculation.

B. Classification of Methods

The methods divide by the logic they use to select a price.

• Cost-based, actual-price methods: issues are priced at prices actually paid.
  • FIFO (First-In, First-Out): oldest cost charged first.
  • LIFO (Last-In, First-Out): newest cost charged first.
  • Base stock: a minimum quantity is held permanently at its original cost, the surplus priced by FIFO or LIFO.
• Average-price methods: issues priced at a blended rate.
  • Simple average: arithmetic mean of unit prices in stock, ignoring quantities.
  • Weighted average: total value in stock divided by total quantity, recomputed after each receipt.
• Notional-price methods: issues priced at a predetermined or market rate.
  • Standard price: a fixed planned rate; differences go to a variance.
  • Replacement price: the current market cost on the issue date.

C. Basis of Selection

The method chosen depends on conditions in the market and the aims of management.

• Price trend: in rising prices FIFO leaves higher-valued stock and lower issue cost, while LIFO does the reverse.
• Nature of material: perishable or dated goods suit FIFO; interchangeable bulk materials tolerate averaging.
• Reporting aim: matching current cost to current revenue favours LIFO or replacement price; a truthful balance-sheet stock value favours FIFO.
• Statutory acceptance: many accounting frameworks permit FIFO and weighted average but disallow LIFO for financial statements, which constrains choice.

III. FIFO — First-In, First-Out

Oldest costs are issued first

A. Statement of the Method

FIFO assumes the materials received earliest are issued earliest, so each issue is priced from the oldest unexhausted purchase lot, and closing stock is valued at the most recent purchase prices.

• Cost-flow rule: exhaust the earliest lot fully before drawing on the next.
• Closing stock composition: made up of the latest receipts, so its value tracks recent prices.
• Effect in rising prices: issue cost is low (old, cheap lots) → cost of goods sold low → reported profit high → closing stock high.
• Effect in falling prices: the reverse — higher issue cost, lower profit, lower closing stock.

B. Worked Example

The example shows how each issue draws on the oldest lot first.

• Transactions:
  • Jan 1: received 100 units @ ₹10 = ₹1,000
  • Jan 5: received 100 units @ ₹12 = ₹1,200
  • Jan 8: issued 150 units
• Pricing the issue of 150 units:
  
  TEXT

    100 units from Jan 1 lot @ ₹10 = ₹1,000
     50 units from Jan 5 lot @ ₹12 =   ₹600
    Total issue value              = ₹1,600

• Closing stock: 50 units left, all from the Jan 5 lot @ ₹12 = ₹600.
• Check: issues ₹1,600 + closing ₹600 = ₹2,200 = total receipts ₹1,000 + ₹1,200. ✔

C. Applications and Limitations

FIFO suits materials that must physically rotate but reacts slowly to price change on the cost side.

• Suited to: perishable, fashion, or dated stock where old units must move first.
• Advantages:
  • Realistic stock value: closing stock reflects near-current prices.
  • Actual cost basis: no artificial figures; each issue is a price actually paid.
  • Statutory acceptance: permitted under most reporting standards.
• Limitations:
  • Outdated issue cost: production is charged with old prices, understating current cost when prices rise.
  • Overstated profit: the low issue cost inflates paper profit and hence tax.
  • Comparability problem: two identical jobs run days apart may carry different material costs as lots switch over.

IV. LIFO — Last-In, First-Out

Newest costs are issued first

A. Statement of the Method

LIFO assumes the materials received most recently are issued first, so each issue is priced from the latest purchase lot, and closing stock is valued at the oldest purchase prices.

• Cost-flow rule: draw on the newest lot until it is exhausted, then move back to earlier lots.
• Closing stock composition: made up of the earliest receipts, so its value can become badly out of date.
• Effect in rising prices: issue cost is high (new, dear lots) → cost of goods sold high → reported profit low → closing stock low.
• Effect in falling prices: the reverse — lower issue cost, higher profit, higher closing stock.

B. Worked Example

Using the same transactions, the issue now draws on the newest lot first.

• Transactions: identical to Section III.B.
• Pricing the issue of 150 units:
  
  TEXT

    100 units from Jan 5 lot @ ₹12 = ₹1,200
     50 units from Jan 1 lot @ ₹10 =   ₹500
    Total issue value              = ₹1,700

• Closing stock: 50 units left, all from the Jan 1 lot @ ₹10 = ₹500.
• Contrast with FIFO: same physical issue costs ₹1,700 under LIFO versus ₹1,600 under FIFO; the ₹100 difference is exactly the difference in the two closing-stock values (₹600 vs ₹500).

C. Applications and Limitations

LIFO matches current cost to current revenue but leaves a distorted balance sheet.

• Suited to: conditions of steadily rising prices where matching current input cost to sales is the priority.
• Advantages:
  • Current-cost matching: issues carry recent prices, so cost of goods sold reflects near-market conditions.
  • Profit smoothing in inflation: the higher issue cost curbs overstated profit and defers tax.
  • Actual cost basis: like FIFO, uses prices actually paid.
• Limitations:
  • Outdated stock value: closing stock sits at old, low prices and misrepresents asset value.
  • Statutory rejection: disallowed under IFRS and many national standards for financial reporting.
  • Layer liquidation distortion: if stock falls below normal, old cheap layers are issued, suddenly inflating profit — the opposite of the intended effect.

V. FIFO versus LIFO — Direct Comparison

How the paired methods diverge under changing prices

A. Point-by-Point Contrast

The two methods are mirror images, differing only in which lot is deemed to leave first.

1. FIFO: oldest cost to issues, newest cost to stock.
   • Issue cost in inflation: low → profit high → tax high.
   • Closing stock: near current price, realistic on the balance sheet.
2. LIFO: newest cost to issues, oldest cost to stock.
   • Issue cost in inflation: high → profit low → tax deferred.
   • Closing stock: dated, understated on the balance sheet.

• Shared traits: both use actual purchase prices, both need a perpetual ledger to track lots, and in stable prices both give identical results.
• Where they meet: when purchase price never changes, issue cost and closing stock are the same under either rule, so the choice matters only when prices move.