Cost Accumulation: Materials/Inventory Valuation

Learning Outcomes

  • By the end of this topic, you should be able to:
    • Understand how the valuation of inventory movements differs from the physical movements of goods in a warehouse.
    • Describe the main characteristics of each inventory valuation method.
    • Calculate issue prices and inventory valuations under the LIFO, FIFO, and AVCO methods.
    • Understand the principles of inventory control systems.
    • Calculate a range of common inventory control measures including economic order quantity.

Inventory Valuation

  • Material Costs:
    • Direct material costs: Costs directly associated with a product.
    • Indirect material costs: Costs not directly associated with a product; included under production or non-production overheads.
    • Most businesses hold direct materials in inventory (e.g., components, raw materials).
    • Direct materials often appear first in a cost summary and form part of the prime cost.

Cost Summary Template

  • Direct Costs:
    • Direct material: x
    • Direct Labor: x
    • Direct Expenses: x
    • Prime Cost: x
  • Production Overheads:
    • Factory Rent: x
    • Factory Heat and Light: x
    • Production Cost: x
  • Non-Production Overheads:
    • Selling and Distribution:
      • Sales staff salaries: x
    • Administration Overheads:
      • Admin staff salaries: x
    • Total Cost: x

Valuation of Inventories: Ancient and Modern?

  • Purchases and issues of inventory for production (or sales) need to be recorded to determine the balance of inventory held at any time without physical counts.
  • One way to do this is using a stores ledger card.
  • Computerized systems use electronic devices like barcode readers to reduce errors from manual input and speed up the process.

Definition of Inventory Cost

  • Basic Principle: Valuation of cost (a cost accounting function) is required for financial accounting.
  • For brought-in items, cost is the purchase cost plus additional costs necessary for acquisition.
  • Assumption in Inventory Valuation: Valuation methods differ from inventory movement.
  • Physical movement of goods does not necessarily follow valuation methods or issue prices from inventory.

Methods of Inventory Valuation

  • First In, First Out (FIFO):
    • Inventory issues are priced at the price of the oldest batch in inventory until the entire batch is consumed, then the next oldest batch is used, and so on.
    • The physical inventory movement may not reflect the valuation.
  • Last In, First Out (LIFO):
    • Inventory issues are priced at the price of the newest batch in inventory until the entire batch is consumed, then the next newest batch is used, and so on.
    • The physical inventory movement may not reflect the valuation.
  • Average Cost (AVCO):
    • AVCO is a perpetual weighted average cost system where the issue price is recalculated after each receipt considering both quantity and monetary value.

Effect on Profit and Closing Inventory Valuations (In times of Rising Prices)

  • FIFO: High Profits and closing inventory valuation
  • AVCO: Middle profits and closing inventory valuation
  • LIFO: Low profits and closing inventory valuation

Class Example 1

  • Sid makes the following purchases for resale:
    • January 10, 20X1: 50 units @ £1.00 = £50.00
    • January 20, 20X1: 60 units @ £1.10 = £66.00
    • January 30, 20X1: 40 units @ £1.25 = £50.00
    • Total: 150 units, £166.00
  • On January 31, 20X1, Sid sells 60 units of inventory for £1.50 each.

Class Example: FIFO

  • Cost of the oldest batch is charged to the issue.
    • 50 units purchased @ January 10, 20X1 (£1.00): £50.00
    • 10 units purchased @ January 20, 20X1 (£1.10): £11.00
    • Cost of sale: £61.00
  • Remaining inventory valuation:
    • 50 units purchased @ January 20, 20X1 (£1.10): £55.00
    • 40 units purchased @ January 30, 20X1 (£1.25): £50.00
    • Closing inventory: £105.00
  • Profit calculation:
    • Revenue: £90.00
    • Costs of sale: £61.00
    • Profit: £29.00

Class Example: LIFO

  • Cost of the newest batch is charged to the issue.
    • 40 units purchased @ January 30, 20X1 (£1.25): £50.00
    • 20 units purchased @ January 20, 20X1 (£1.10): £22.00
    • Cost of sale: £72.00
  • Remaining inventory valuation:
    • 50 units purchased @ January 10, 20X1 (£1.00): £50.00
    • 40 units purchased @ January 20, 20X1 (£1.10): £44.00
    • Closing inventory: £94.00
  • Profit calculation:
    • Revenue: £90.00
    • Costs of sale: £72.00
    • Profit: £18.00

Class Example: AVCO

  • Weighted average cost is used.
  • Average price: \frac{£166}{150} = £1.107…
  • Cost of sale: £1.107… \times 60 \text{ units} = £66.40
  • Remaining inventory valuation:
    • Closing inventory: £1.107… \times 90 \text{ units} = £99.60
  • Profit calculation:
    • Revenue: £90.00
    • Costs of sale: £66.40
    • Profit: £23.60

Class Example 2

  • Calculate the value of inventory at the end of the period using FIFO, LIFO, and AVCO.
  • Comment on the differences found in inventory valuation and the value of goods issued.
  • Given Information:
    • September 1st: Receipts: 150 Units, Purchase Price: 4.00
    • September 5th: Receipts: 100 Units, Purchase Price: 4.50
    • September 6th: Issues: 80 Units
    • September 12th: Issues: 100 Units
    • September 20th: Receipts: 90 Units, Purchase Price: 4.80
    • September 24th: Issues: 80 Units

Comparison of Inventory Valuation Methods

  • Actual Cost System?
    • The value of items held in inventory represents an actual cost which was paid for inventory.
  • Acceptable to SSAP 9 / IAS 2?
    • SSAP 9 and IAS 2 represent accounting standards for financial reporting purposes. If LIFO is used, then an adjustment would have to be made to the financial accounts for reporting purposes. As such under LIFO there may be unrealised gains and losses.
  • Acceptable to HMRC?
    • HMRC is the UK tax authority. HMRC does not allow the use of LIFO, if used an adjustment would therefore have to be made in order to calculate tax due.
  • Easy administration?
    • Issuing inventory at different issue prices for different batches is time consuming and logistically difficult. Using an average cost is significantly quicker and easier.
  • Easy comparison between jobs?
    • As issue prices fluctuate less under AVCO, this makes comparing the costs of different jobs much easier.
  • Represents good store keeping practice?
    • Physical inventory movements do not necessarily follow the same pattern as inventory valuation. That is an old item of inventory may physically be issued first, though it may be issued at a recent issue price. Good store keeping practice would be to issue old items first, the FIFO valuation method mimics this.
  • Prices of inventory issues?
    • That is the price at which inventory is charged to jobs within the business.
  • In times of rising prices…
    • FIFO: Lag behind market value. Lower
    • AVCO: Somewhere in between. Middle
    • LIFO: Up to date and in line with market. Higher
  • In times of falling prices…
    • FIFO: Higher
    • AVCO: Middle
    • LIFO: Lower

Advantages and Disadvantages of Holding Inventory

  • Advantages:
    • Meeting Customers needs and seasonal demand fluctuations.
    • Taking advantage of Bulk discounts.
    • Reducing ordering and Holding costs.
  • Disadvantages:
    • Storage costs.
    • Capital tied up in inventory.
    • Inventory Deterioration, obsolescence, and theft.

Additional Tasks

  • Attempt the following Questions:
    • Self Practice Question 2.1 Available on Moodle
    • Seminar Question 2.2 Attempt during Seminar session
    • Question 2.3 Attempt and Discuss unclear areas with your Seminar tutor