Inventory can be defined as tangible asset held for sale, or production of goods or services for sale, in the ordinary course of business.
- Manufacturing Concern : In Manufacturing Concern, inventory includes Finished goods. Work-in-progress. Raw Materials. Stores, Components, etc
- Trading business : In Trading business, inventory means stock of tradable goods
Value of Inventory (Closing stock) is normally determined as
Opening Stock + Net Purchase + Direct Expenses – Cost of Goods Sold (CoGS) = Closing Stock
Purpose of Inventory Valuation
- Stock Valuation : Closing stock appears in the asset side of balance sheet. So, Inventory valuation is essential to get Balance Sheet.
- Gross Profit: Gross profit depends on value of Opening and Closing stock. If value of closing stock is more, gross profit will be more and if value of closing stock is less, gross profit will be less.
Closing stock of the current year is carried as opening stock of the next year. Cost of goods sold of the next year will be affected due to valuation of closing stock of current year. So, correct valuation of stock is very Important.
- Management Decision: Inventory or stock figures are also required by management for business Decisions, like evaluation of Working Capital, etc.
- Statutory Compliance : The value of each type of Inventory (Raw materials, Work in process, Finished Materials), has to be reported separately in Financial Statement
Basis of Inventory Valuation
Value of Inventory is calculated as Cost Price or Net Realizable Price, whichever is lower.
Cost is determined as Money expended on acquisition of goods. Net Realizable Value is determined as estimated selling price in ordinary course of business, less estimated cost of completion and estimated cost necessary to sale.
All cost of Purchase (including inward freight and other direct purchase expenses to acquire the goods) are included in Cost of Purchased Goods, and so included in Inventory Valuation. For manufactured goods, all direct manufacturing costs are included. Expenses not directly related to Cost of Purchase or Manufacture (like Sales, Administrative, Finance Cost etc., are not included in Inventory valuation.
Abnormal Cost or losses are not included in Inventory Cost. Storage Costs are not normally included, unless they are necessary for further production.
Additional acquisition Costs
It is already explained that Inventory Cost also includes the direct cost of Purchase to bring the Inventory into stock (like Freight & Carriage Inwards, Insurance, Taxes etc, apart from basic materials cost. When common cost is incurred for several items purchased, all such cost should be apportioned to each Item purchased on some rational basis and should be included in Purchase Cost while computing Inventory value.
In the examples discussed, we assume that the cost of materials include all such purchase costs
Stock Value Computation – Examples
Example -1 From the following information ascertain the value of stock as on 31st March, 2021 and also the profit for the year
1) Stock as on 01.04.2020 : 14,250, 2) Purchases 76,250, 3) Manufacturing Expenses 15,000, 4) Selling Expenses 6,050,
5) Administrative Expenses 3,000, 6) Financial Charges 2,150, 7) Sales 124,500
At the time of valuing stock as on 31st March, 2014, Rs.1,750 was written off on an item, originally purchased for Rs.5,000 and sold during the year at Rs.4,500. Barring this item, gross profit in 2014-15 was 20% on sales. Compute Stock value as on 31.3.2015 & Profit for the financial year 2014-15
Computation of Value of Stock As on 31st March, 2021
a. Opening Stock = 14,250
b. Cost of Purchases : Purchases (76,250 ) + Written off during previous year (1,750) + Mfg Exp (15,000 ) = 93,000
c. Cost of Goods Sold : Sales = Normal Sales (124500) – Abnormal Sales (4500 ) = 1,20,000, Cost of Goods Sold = 80% of 1,20,000 = 96,000 + Cost of Goods of Abnormal Sales (5000 ) = 1,01,000
d. Value of Stock As on 31st March, 2015 (a+b-c) = 14250+93,000 – 1,01,000 = 6,250
Example – 2. ABC Co had 5 Pcs of Ceiling Fan in Stock valued at Rs 15000. It purchased 6 Pcs @ 3200 / Pc and sold 7 Pcs @ 4000 each. It incurs @ 2% on various purchase Cost like Freight, Clearing Charges etc. It spends @ 5% on publicity of business. Find the Inventory value of its closing stock.
Soln: Cost of Purchase = 3200×6=19200 + Expenses of purchase @ 2% on 19200=19200+2%on 19200= 19200+384=19584.
Average cost of Ceiling Fan including opening stock = (15000 for 5 Pcs+19584 for 6 Pcs) = 34584 for 11 Pcs = 3144 per Pc.
So, the value of Inventory of 4 pcs (5 opening stock +6 purchases – sold 7) in stock = 4x 3144= 12576
Note : The publicity expenses for running his business would not be considered for Inventory Valuation
Inventory Valuation Methods
- Cost Price or Historical Cost : Computed on Cost of materials consumed and production Cost.
Under this method, the Inventory may be values on basis of Specific Cost. First-In-First-Out Method. Last-In-First-Out Method. Highest In, First Out. Next In, First Out. Base Stock Price. Simple Average Cost. Previous Month Average. Weighted Average Cost. Moving Average Cost
- Market Price : Under this method, inventoryisValued at Market Price. As it leads to unrealized profit, it is normally used for managerial purpose and not for stock value in books of accounts. Various methods are adopted like, Replacement Price. Net Realizable Value. Current Selling Price. Discounted Future Cash receipt.
- Cost or Market Price : Under his method, inventory isValued on the basis of Cost or Market Price, whichever is less. Method like Global or aggregate Method. Item by Item Method. Group Method are normally adopted.
Cost Price or Historical Cost Inventory Valuation Method
Cost Price : Cost Price means the cost of materials consumed and its manufacturing cost,
Cost Price = Purchase cost of Raw Materials + Direct Expenses + Overheads.
Purchase Cost is determined on various methods, considering the factors like time, frequency, volume etc. of purchase.
- Specific Cost : Each type of inventory is valued at its real price. This method is adopted where material is purchased for a specific job for a specific purpose, where a few Items are handled.
- First-In-First-Out (FIFO) : Goods purchased first are issued at the respective cost price. So, the rate of oldest stock-in-hand is applied for each issue. So, closing Stock represents what is acquired latest
- Last-In-First-Out (LIFO) : Goods purchased last are issued at the respective cost price. So, the rate of latest purchase stock-in-hand is applied for each issue. So, Closing stock represents stock which was acquired earlier.
- Highest In, First out (HIFO) : Goods of highest price in hand are issued first. Values of closing stock represent Items of lower prices.
- Next In, First out Method (NIFO) : Goodsare issued at ordered price, yet to be received. Past prices are not considered.
- Base Stock Price : It is valued at the price which is the price of base stock is maintained. The Base Stock portion of closing stock is valued at base stock price. The excess is valued according to any method determined by management.
- Simple Average Cost : It is computedonAverage price of goods purchased up to the date of issue (just rate is considered, without considering the quantity of purchase).
- Previous Month Average : Price of issue of material of current month is computed on average price of the previous month. It may result in closing stock value in negative amount.
- Weighted Average Cost : It is computedonAverage price of goods purchased (the total cost of the purchase quantity), up to the date of issue. This is widely used for book valuation, due to simplicity, consistency & rationality.
- Moving Average Cost : Value of issue of materials is computed onWeighted average price of materials purchased before the date of issue.
Market Price Inventory Valuation Methods
Under this method, Stock is valued at Market Price. However, this may lead to unrealized profit. Hence, it is normally used for managerial purpose and not for stock value in books of accounts.
Stock value under this method may be computed in any of the following ways
- Replacement Price: Replacement price means the price at which goods could be purchased in the market on the stock valuation date.
- Net Realizable Value: It is the estimated selling price at which goods could be sold on the date of valuation of closing stock (Sale Value less the sales expenses to be incurred).
- Current Selling Price: This is the price at which goods are available in the market on the date of valuation of stock.
- Discounted Future Cash receipt: If goods are to be delivered at a future date (over long period), the stock is valued at present value of the amount to be received at a future date, by discounting it at a reasonable interest rate.
Cost or Market Price Inventory Valuation Methods
Under this method, Stock is valued at cost or market price whichever is lower. The Cost price is computed applying following methods :
- Global or aggregate Method: Total of Cost Prices and Market prices of each Type of Stock are aggregated and stocks are valued at the lower of the two aggregates.
- Item by Item Method: Cost price and market price of each Item is computed and stock is valued at lower of them for each item.
- Group Method: Stocks are grouped into various groups according to their nature or type. Lower amount of each group aggregate is treated as value of closing stock.
First-In-First-Out (FIFO) Inventory Valuation Method
Goods purchased first are issued at the price at which they were acquired (First In First Out). So, the rate of oldest stock-in-hand is applied for each sale or consumption.
- Merits of FIFO Method : Computations are based onactual cost, so unrealized profit or negative stock value are eliminated. Stock value remains close to current prices, so is more realistic. This method is more logical, equitable & rational as it is based on the dictum that whatever comes, goes first, and is very suitable when price are quite stable
- Demerits of FIFO Method : This method is not suitable in inflation oriented market, where price is going up, as the production is shown at a cost less than what really is, and may lead to loss. Cost of different time cannot be compared. Manual computation is complicated.
First-In-First-Out (FIFO) Inventory Valuation Method Examples
Last-In-First-Out Method or LIFO Inventory Valuation Method
Goods which are acquired last are issued first (First In First Out). Closing stock represents old stock in hand
- Merits of LIFO Method : Representrealistic cost of issues as the latest prices are used for determining the cost, particularly in inflationary market. Value of closing stock is reasonable as it is based on cost price, so it does not result in unrealized profit
- Demerits of LIFO Method : Closing Stock carried over long time may not be realistically valued. It is not allowed as per AS-2 and also not also favoured by Tax Authorities. So, it is normally not used for computation of Book value of Stock
LIFO Inventory Valuation Methods Method – Example
Weighted Average Cost Inventory Valuation Method
Total Cost of Purchase and Totalquantity purchased for a period are summed and average price per unit (Called Weighted Average Cost) is computed therefrom. This unit rate is applied for computation of Stock Value
Weighted Average Price Per Units = (Total cost of goods purchased during the period) / Total quantity purchased during the period.
Stock Value = Quantity X Weighted Average Cost
Weighted Average Cost Inventory Valuation Method Example
Adjusted Selling Price Inventory Valuation Method
Mostly all Inventory valuation methods (FIFO, LIFO, Weighted Average etc) are based on Historical Cost. However, in some cases, the Historical Cost of each Item cannot be accurately computed.
For example, in retail business, where numerous Items are purchased and various common purchase cost are incurred, cost of purchase of each Item cannot be accurately computed easily.
However, the normal gross profit of each category of Item can be more reliably computed, as the traders mostly fix the sales price, by keeping a standard percentage of margin on Sales price over basic price. The cost of Inventory (or Cost of sales) is then computed by reducing the standard profit margin on sales price. Accordingly the value of Inventory is computed.
Adjusted Selling Price Inventory Valuation Method- Examples
A retailer purchase materials of Rs 1,50,000, on which he received trade discount at 10%, paid sales Tax @10% after trade Discount and incurred transport cost of Rs 2000. He sold goods for 180000, and still had goods worth of sales price 30000. Find the cost of Inventory using Adjusted Selling price method
Soln : Cost of Purchase = Materials Value 1,50,000- Trade Discount 15000 (@10% on 1,50,000) + Sales tax 13500 (@10% on 1,35,000) + Transport Cost 2000= 1,50,500
Sales value of Goods purchased = Sales 1,80,000 + Inventory in hand 30,000 = 2.10,000
Gross Profit margin on Sales in % = [(2,10,000-1,50,500) / 2,10,000] x 100% = (59500/ 210000) / 100 % =28.33%
So, Inventory Value = Sale Value of Inventory 30000 – Margin on Sales Value (30000×28.33%) = 30000- 8499= 21501
Physical Inventory Measurement System
Stock of materials is to be physically verified for the purpose of Accounting and also to detect loss pilferage etc. At Stock taking (often referred as physical verification of Stock), Physical counting or weighment of stock is done and recorded in stock sheet, for computation of value of stock. There are several methods of planning the date and frequency of stock taking.
- Periodic Physical Inventory Measurement System
Stock measurement is done after the close of according period.
This system is suitable for small business, but large business may not be able to take stock in a day, or suspend regular stock movement.
It also cannot normally detect pilferage, manipulation, theft etc., as stock is taken only at the end of period. However, normally small business find this system of stock-taking most suitable.
- Perpetual Physical Inventory Measurement System
Stock-taking is done continuously throughout the accounting period.
Stock movement operations (Receipt & Issues of materials) continues as usual and recorded in store ledger. At intervals, physical stock is counted for selected items, on random (or planned basis) and compared with store ledger balance.
No operation of stock movement need to be suspended during stock-taking period. Loss or damage of material is detected early.
Periodic vs Perpetual Inventory Measurement System
The subtle differences between Periodic & Perpetual method of Physical Stock Verification methods are now explained.
|Basis||Periodic Inventory System||Perpetual Inventory System|
|Time||Periodic Stock is taken only at the end of accounting period.||Perpetual Stock taking is done continuously throughout the year|
|Method||With Periodic Stock method, Stock is arrived on the basis of Physical stock.||Perpetual stock-taking is done and compared with book stock. Discrepancies adjusted in book stock|
|Final Accounts||With Periodic Stock method, Final accounts may be delayed as entire task in carried at the end of financial period.||With Perpetual stock-taking, Final accounts may be prepared earlier, as only a small portion of work is left till end of the year.|
|Control||In Periodic Stock method, Control on stock is lenient. In fact, there is hardly any control||Perpetual stock-taking enables good control on stock.|
|Loss||In Periodic Stock method, losses are detected at a very late stage, or may not be detected at all.||In Perpetual stock-taking, Losses are detected early stage.|
|Economy||Periodic Stock method is relatively economical. Suitable for small organizations, but not very practical for large organisations||Perpetual stock-taking is relatively costly, but quite suitable for large organisations|
Physical Inventory Measurement Adjustments
In Balance Sheet, the value of stock as on the date of Balance Sheet is to be shown.
As physical stock taking for all stocks cannot be done in one day, the stock taking task may be spread over few days, just before and after the Balance Sheet Date.
The actual closing stock is computed from the physical stock after adjustment of movement of stock before or after the stock verification, as the case may be.
Adjustments for Physical Inventory Measurement before Balance Sheet Date
a.Stock as on stock taking date
b. Add : Inwards (Receipts & Issue Returns) during the stock taking date to balance sheet date
c. Less : Outwards ( Issue & Receipt Returns) during the stock taking date to balance sheet date
d. Closing Stock on the date of Balance Sheet (a+b-c)
Adjustments for Physical Inventory Measurement after Balance Sheet Date
a. Stock as on stock taking date
b. Less : Inwards (Receipts & Issue Returns) during balance sheet date to stock taking date .)
c. Add: Outwards (Issue & Receipt Returns) during the stock taking date to balance sheet date
d. Closing Stock on the date of Balance Sheet (a-b+c)
Adjustment for Stock Taken after Balance Sheet Date
Balance Sheet (e.g as on 31st March 2015) is prepared on the basis of Stock taken at a later date (e.g.on 15th April 21), Adjustments were made for transactions taking place between Balance Sheet date & Stock Taking Date.
Physical Inventory Measurement Adjustments – Examples
A Trader prepares his account on 31st March each year. On 15th April, 2021, total cost of goods in his godown came to Rs.50,000.
1) Sales Rs.41,000 (Including cash sales Rs.10,000). 2) Purchase Rs.5,034 (Including cash purchase Rs.1,900)
3) Sales Return Rs.1,000. 4) On 15th March goods of the sale value of Rs.10,000 were sent on sale or return basis. who returned 40% of the goods on 10th April approving the rest. 5)The customer was billed on 16th April. 6) A trader having received goods costing Rs.8,000 in March, for sale on consignment basis, 20% of the goods sold by 31st March, and another 50% by the April. These sales are not included in above sales.
Goods are sold by the trader at a profit of 20% on sales. Ascertain the value of inventory as on 31st March, 2010.
- Cost of goods sold : Goods sold after 31st March, till stock-taking = 41,000(sales) – 1000 (sales Return) = 40,000. As Goods were sold at a profit of 20% on sales, cost of goods sold = [40,000 x (80/100)] = 32,000.
- Cost of stock with customer on approval basis : 10000 (Goods sent on approval or return basis ) – 4,000 (Return from customer on approval) = 6,000. So, Cost of stock with customer = [6,000 x (80/100)] = 4,800.
- Stock belonging to consignors: Out of goods received on Consignment basis, sold 20% by (31st March), and another 50% (by April). So (50% + 20%) = 70% of the goods sold. Therefore, stocks remaining to consignors = (100% – 70%) = 30% of the goods received on consignment basis of Rs.8,000. So Value of stock with consignors = (8,000 x 30/100) = 2,400.
Computation of Value of Stock as on As on 31st March, 2015
Stock in godown on 15th April = 50,000
Add : Cost of goods sold after 31st March, till stock-taking = 32,000 (WN 1) + Cost of stock with customer = 4800 (WN 2) = 36,800
Less : Cost of goods purchased after 31st March till stock-taking is made = 5034 + Stock belonging to consignors = 2400 (WN 3) = 7434
Value of Stock as on As on 31st March, 2021 = 50,000+36,800- 7434 = 79,366
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