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Stock or Inventory Valuation

Inventory costs or valuation is the cost associated with an entity's inventory at the end of a reporting period. It forms a key part of the cost of goods sold calculation. This valuation appears as a current asset on the entity's balance sheet. The inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert it into a condition that makes it ready for sale, and have it transported to the proper place for sale. Do not add any administrative or selling costs to the cost of inventory. The costs that can be included in an inventory valuation are:

• Direct labour.
• Direct materials.
• Factory overhead.
• Freight in.
• Handling.
• Import duties.

Inventory Valuation Methods

• The first in, first out method, where you assume that the first items to enter the inventory are the first ones to be used.
• The last in, first out method, where you assume that the last items to enter the inventory are the first ones to be used.

Whichever method chosen will affect the inventory valuation recorded at the end of the reporting period.

FIFO (first in first out)

FIFO stands for first in first out and implies that the inventory which was added first to the stock will be removed from stock first. Therefore, the inventory will leave the stock in the same order as that in which it was added to the stock. It means that whenever the inventory is reported as sold (either after conversion to finished goods or as it is), its cost will be taken equal to the cost of the oldest inventory present in the stock. It, in turn, means that the cost of inventory sold as reported on the profit and loss statement will be taken as that of the oldest inventory present in the stock. On the other hand, on the balance sheet, the cost of the inventory still in stock will be taken equal to the cost of the latest inventory added to the stock.

LIFO (last in first out)

LIFO stands for Last In, First Out, which implies that the inventory which was added last to the stock will be removed from the stock first. So the inventory will leave the stock in an order reverse of that in which it was added to the stock. It means that whenever the inventory is reported as sold (either after conversion to finished goods or as it is), its cost will be taken equal to the cost of the latest inventory added to the stock. This, in turn, means that the cost of inventory sold as reported on the profit and loss statement will be taken as that of the latest inventory added to the stock. On the other hand, on the balance sheet, the cost of the inventory still in stock will be taken equal to the cost of the oldest inventory present in the stock.

Example:

Suppose that a company produces and sells its product in batches of 100 units. If inflation is positive, the cost of production will go on increasing with time. So assume that  batch of 100 units is produced within each period and the cost of production increases after each successive period.

So if the cost of production for producing 1 unit is $ 10 in the first period, it could be $ 20 in the second period, $ 30 in the third period and so on. Refer to the table below for the summary:

It should be obvious that the company will not be able to sell exactly 100 units of products during each period. It will have to sell them according to the orders it receives and also according to the availability of the products in its stock of finished goods. So suppose that the company gets orders of a total of 150 units after producing the third batch of 100 units. This company already produced a batch of 100, then another batch of 100 and a third batch of 100. After producing the third batch of 100, it receives an order for 150. It can use either the FIFO or LIFO method as its accounting method to evaluate the stock on hand.

Inventory Valuation using the FIFO method

Now, if a company chooses to use the FIFO method of inventory accounting, the cost of goods sold will be taken equal to the cost of the first 150 units produced (remember “first in, first out”) out of all the 300 units available in the stock. Now, the first 150 units produced include the 100 units of Batch No. 1 plus any 50 units of Batch No. 2. Hence, the Cost of Goods Sold (COGS) will be equal to (100 * $ 10) + (50 * $ 20) = $ 2,000.

Also, the value of the remaining inventory of the finished products will be equal to the cost of the remaining 150 units in the stock, i.e., the remaining 50 units of Batch No. 2 and the 100 units of Batch No. 3. Hence, the value of Inventory of finished goods that will be reported on the Balance Sheet of the company would be equal to (50 * $ 20) + (100 * $ 30) = $ 4,000.

Inventory Valuation using the LIFO method

Now, if a company chooses to use the LIFO method of inventory accounting, the cost of goods sold will be taken equal to the cost of the last 150 units produced (remember “last in first out”) out of all the 300 units available in the stock. Now, the last 150 units produced include the 100 units of Batch No. 3 plus any 50 units of Batch No. 2. Hence, the cost of goods Sold (COGS) will be equal to (100 * $ 30) + (50 * $ 20) = $ 4,000.

Also, the value of the remaining inventory of the finished products will be equal to the cost of the remaining 150 units in the stock, i.e., the remaining 50 units of Batch No. 2 and the 100 units of Batch No. 1. Hence, the value of inventory of finished goods that will be reported on the balance sheet of the company would be equal to (50 * $ 20) + (100 * $ 10) = $ 2,000.

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