Unit 9: Inventory Valuation - Subjective Questions

Inventory valuation refers to the process of assigning a monetary value to the stock of materials held by an organisation and to the materials issued to production.

Importance of pricing material issues:

• Cost determination: The price at which materials are issued directly affects the cost of production and, therefore, the cost of the final product.
• Profit measurement: Since closing stock value influences the cost of goods sold, it directly affects reported profit.
• Inventory valuation in the Balance Sheet: Closing stock appears as a current asset, so its valuation affects the financial position.
• Decision making: Accurate material costs help in pricing decisions, tendering, and cost control.
• Consistency and comparability: A proper method ensures comparability of results across periods.

Because the purchase price of materials keeps changing, a systematic method of pricing issues must be adopted to charge issues consistently.

The important methods of pricing material issues are:

• First-In-First-Out (FIFO): Materials are issued in the order in which they were received; issues are priced at the cost of the earliest lots.
• Last-In-First-Out (LIFO): Materials received most recently are issued first; issues are priced at the latest purchase cost.
• Simple Average Method: Issue price = average of the prices of materials in stock, without regard to quantities.
• Weighted Average Method: Issue price = total cost of materials in stock divided by total quantity in stock.
• Highest-In-First-Out (HIFO): The most expensive materials are issued first.
• Base Stock Method: A minimum quantity of stock is always valued at its original cost; the balance is priced by FIFO or LIFO.
• Standard Price Method: Materials are issued at a pre-determined standard price.
• Replacement/Market Price Method: Issues are priced at the current market or replacement price.

The choice of method depends on the nature of business, price fluctuations, and management policy.

FIFO assumes that materials are issued in the order in which they are received. The earliest (oldest) stock is issued first, and issues are therefore priced at the cost of the oldest lot until it is exhausted.

Advantages:

• Simple and logical, follows the natural order of consumption.
• Closing stock is valued close to current market price.
• No unrealised profit or loss arises since actual purchase prices are used.
• Suitable for materials that are perishable or subject to obsolescence.

Disadvantages:

• In times of rising prices, issues are charged at older (lower) prices, understating product cost.
• Requires more calculations when purchase prices fluctuate frequently.
• Comparison of jobs may be difficult since identical materials may be charged at different prices.
• Increases clerical work when many lots exist.

In rising prices: FIFO gives lower cost of goods sold and higher profit, with closing stock valued at recent higher prices.

LIFO assumes that the materials received most recently are issued first. Issues are therefore priced at the cost of the latest purchases.

Advantages:

• Issues are charged at current (recent) prices, so product cost reflects current market conditions.
• During inflation, it matches current costs with current revenues, giving a more realistic profit figure.
• Provides a hedge against inflation and reduces reported profit (and hence tax) in rising prices.

Disadvantages:

• Closing stock is valued at old prices, which may not reflect current market value.
• Not permitted under many accounting standards (e.g., IAS 2 / Ind AS 2 prohibit LIFO).
• More complex calculations when prices fluctuate.
• Comparison between jobs becomes difficult.

In rising prices: LIFO gives higher cost of goods sold and lower profit, with closing stock understated.

Summary: FIFO values closing stock realistically while LIFO values cost of issues realistically.

FIFO – oldest stock issued first.

Jan 10 Issue (250 units):

• 200 units @ $10 = $2{,}000
• 50 units @ $12 = $600
• Total issue = $2{,}600
• Balance: 250 units @ $12 = $3{,}000

Jan 15 Purchase (400 @ $14):

• Balance: 250 @ $12 + 400 @ $14 = 5{,}600 = $8{,}600

Jan 20 Issue (500 units):

• 250 units @ $12 = $3{,}000
• 250 units @ $14 = $3{,}500
• Total issue = $6{,}500
• Balance: 150 units @ $14 = $2{,}100

Closing stock = 150 units @ $14 = $2{,}100

LIFO – latest stock issued first.

Jan 10 Issue (250 units):

• 250 units @ $12 = $3{,}000 (from latest lot of 300 @ $12)
• Total issue = $3{,}000
• Balance: 200 @ $10 + 50 @ $12 = 600 = $2{,}600

Jan 15 Purchase (400 @ $14):

• Balance: 200 @ $10 + 50 @ $12 + 400 @ $14 = $8{,}200

Jan 20 Issue (500 units):

• 400 units @ $14 = $5{,}600
• 50 units @ $12 = $600
• 50 units @ $10 = $500
• Total issue = $6{,}700
• Balance: 150 units @ $10 = $1{,}500

Closing stock (LIFO) = 150 units @ $10 = $1{,}500

Comparison:

• FIFO closing stock = $2{,}100
• LIFO closing stock = $1{,}500

Since prices are rising, FIFO gives a higher closing stock value and lower issue cost, while LIFO gives a lower closing stock value and higher issue cost.

The impact of the two methods depends on the direction of price movement:

During Rising Prices (Inflation):

• FIFO: Issues priced at old (lower) costs → lower cost of goods sold → higher profit; closing stock valued at recent higher prices → higher stock value.
• LIFO: Issues priced at recent (higher) costs → higher cost of goods sold → lower profit; closing stock at old lower prices → lower stock value.

During Falling Prices (Deflation):

• FIFO: Issues priced at old (higher) costs → higher cost → lower profit; closing stock at recent lower prices → lower stock value.
• LIFO: Issues priced at recent (lower) costs → lower cost → higher profit; closing stock at old higher prices → higher stock value.

Key point: FIFO always values closing stock realistically, while LIFO values the cost of issues realistically relative to current market conditions.

Simple Average Method: Issue price = average of the prices of lots in stock (ignoring quantities).

Weighted Average Method: Issue price = Total value of stock ÷ Total quantity of stock (considers quantities).

Illustration: Stock consists of 100 units @ $10 and 300 units @ $14.

Simple Average:

Weighted Average:

Comparison:

• Simple average is easy but inaccurate as it ignores quantity.
• Weighted average is more accurate since it reflects the true cost mix.
• Weighted average smooths out price fluctuations and is widely accepted.

The following factors influence the choice of a pricing method:

• Nature of materials: Perishable materials suit FIFO (oldest first); durable materials may allow LIFO.
• Frequency of price fluctuations: Where prices fluctuate often, weighted average smooths out variations.
• Frequency of purchases and issues: Frequent transactions increase clerical work under FIFO/LIFO.
• Management policy on profit and tax: LIFO reduces profit in inflation (tax saving where permitted).
• Requirements of accounting standards: LIFO is prohibited under IAS 2 / Ind AS 2.
• Need for consistency: The method should be applied consistently for comparability.
• Effect on closing stock and cost: Management may prefer realistic stock values (FIFO) or realistic cost matching (LIFO).
• Clerical effort and cost of operation: Simpler methods are preferred where accuracy is not critical.

Weighted Average = Total value in stock ÷ Total quantity in stock (recomputed after each receipt).

Jan 1: 500 @ $20 = $10{,}000; Rate = $20

Jan 8: 300 @ $24 = $7{,}200

• Balance: 800 units, value $17{,}200
  

Jan 12 Issue (600 @ $21.50): = $12{,}900

• Balance: 200 units @ $21.50 = $4{,}300

Jan 18: 400 @ $26 = $10{,}400

• Balance: 600 units, value $14{,}700
  

Jan 25 Issue (500 @ $24.50): = $12{,}250

• Balance: 100 units @ $24.50 = $2{,}450

Closing stock = 100 units @ $24.50 = $2{,}450

HIFO (Highest-In-First-Out):

• Under this method, the most expensive materials in stock are issued first, regardless of the order of purchase.
• Issues are therefore charged at the highest prices, and closing stock is valued at the lowest prices.
• Objective: To recover the highest cost of materials early and keep stock valued conservatively.
• Rarely used in practice; suited to cost-plus contracts and monopoly conditions.

Base Stock Method:

• A certain minimum quantity (base stock) of material is always maintained and valued at its original (base) cost, treated like a fixed asset.
• This base stock is never issued in normal course.
• The quantity above the base stock is priced using another method such as FIFO or LIFO.
• Objective: To ensure continuity of production and to keep a stable value for the minimum essential stock.
• Its usefulness depends on the pricing method chosen for the excess stock.

Standard Price Method:

• Materials are issued at a pre-determined standard price fixed in advance based on estimates of future prices.
• The difference between actual purchase price and standard price is transferred to a price variance account.
• Advantages: Simplifies pricing, aids cost control, and facilitates comparison of actual with standard.
• Disadvantages: Standard may become outdated if market prices change significantly; requires periodic revision.

Replacement (Market) Price Method:

• Materials are issued at the current market or replacement price prevailing on the date of issue, not at actual cost.
• Advantages: Reflects current economic cost of materials; useful for realistic pricing decisions.
• Disadvantages: Requires constant monitoring of market prices; may produce a profit or loss on the difference between actual and market price; not always acceptable for financial accounting.

LIFO (Last-In-First-Out) is prohibited under IAS 2 (Inventories) and Ind AS 2 for the following reasons:

• Unrealistic balance sheet value: LIFO values closing stock at old (outdated) prices, which may be far from current cost, distorting the financial position.
• Does not reflect actual physical flow: In most businesses, older stock is physically used first, so LIFO does not represent reality.
• Manipulation of profits: Management can manipulate profit by timing purchases at year-end (creating or reducing LIFO layers).
• Reduces comparability: Different LIFO layers make comparison between entities and periods difficult.
• Understatement of assets: In periods of rising prices, LIFO understates inventory value and may understate working capital.

Because of these distortions, accounting standards permit only FIFO and Weighted Average cost formulas.

Stock available before issue on Jan 20:

• 100 @ $50, 200 @ $55, 150 @ $60 (total 450 units)

(a) FIFO – oldest first (300 units):

• 100 @ $50 = $5{,}000
• 200 @ $55 = $11{,}000
• Total = $16{,}000
• Balance: 150 @ $60 = $9{,}000

(b) LIFO – latest first (300 units):

• 150 @ $60 = $9{,}000
• 150 @ $55 = $8{,}250
• Total = $17{,}250
• Balance: 100 @ $50 + 50 @ $55 = 2{,}750 = $7{,}750

Observation: In rising prices, LIFO issue value (16{,}000), confirming that LIFO charges a higher cost to production.

Weighted Average Method: Issue price is computed as total value of stock divided by total quantity, recalculated after each receipt.

Advantages:

• Smooths price fluctuations: Evens out the effect of erratic price changes over the period.
• Logical and rational: Considers both price and quantity.
• Reduces clerical work: A single rate is used until the next purchase.
• Realistic profit: Neither overstates nor understates profit unduly.
• Accepted by accounting standards (IAS 2 / Ind AS 2).

Limitations:

• Recalculation needed after every purchase, which can be tedious.
• Issue price may not match any actual purchase price.
• Requires computation to several decimal places, causing rounding differences.
• Closing stock may not reflect the latest market price precisely.

Overall, it is one of the most widely used and acceptable methods due to its balance of accuracy and simplicity.

The inventory valuation method impacts both the Income Statement and the Balance Sheet:

Effect on Income Statement:

• The method determines the cost of materials issued, which is part of the cost of goods sold (COGS).
• FIFO in rising prices → lower COGS → higher gross profit.
• LIFO in rising prices → higher COGS → lower gross profit.
• This affects reported net profit and, consequently, tax liability.

Effect on Balance Sheet:

• Closing stock is shown as a current asset.
• FIFO values closing stock near current prices → higher asset value in inflation.
• LIFO values closing stock at old prices → understated asset value.

Other effects:

• Working capital and current ratio are affected by the closing stock figure.
• Consistency of method is essential for comparability across periods.
• Choice affects key ratios such as gross profit margin and inventory turnover.

Total units available = 400 + 600 + 500 = 1,500 units

FIFO – issue oldest first (1,200 units):

• 400 units @ $15 = $6{,}000
• 600 units @ $18 = $10{,}800
• 200 units @ $20 = $4{,}000
• Cost of materials consumed = $20{,}800

Closing stock = 1,500 − 1,200 = 300 units

• Remaining from the last purchase: 300 units @ $20
  

Verification (total cost):

Inventory Turnover Ratio measures how many times the average inventory is sold or consumed during a period.

where

Influence of valuation methods:

• The ratio depends on COGS (numerator) and average inventory (denominator), both affected by the pricing method.
• In rising prices under FIFO: COGS is lower and closing stock higher → lower turnover ratio.
• In rising prices under LIFO: COGS is higher and closing stock lower → higher turnover ratio.
• Therefore, the same physical movement of goods can produce different ratios depending on the method used.

Implication: For meaningful comparison, the same valuation method must be used consistently across periods and firms.

Under conditions of fluctuating (up and down) prices, the Weighted Average Method is generally recommended.

Reasons:

• Smoothing effect: It averages out price fluctuations, so neither issue cost nor closing stock is distorted by extreme prices.
• Stability of cost: Product costs remain relatively stable, aiding pricing and budgeting decisions.
• Rational basis: It considers both quantity and price, giving a fair representation of material cost.
• Acceptability: It is permitted under IAS 2 / Ind AS 2 and widely accepted for financial reporting.

Why not FIFO or LIFO here:

• FIFO and LIFO produce widely varying issue prices when prices swing sharply, making cost comparison and job costing difficult.
• LIFO is also disallowed under accounting standards.

Conclusion: For fluctuating prices, the weighted average method provides a balanced, consistent, and standard-compliant basis, though the final choice also depends on the nature of materials and management policy.