Explain the different methods of inventory valuation with the help of suitable examples.
METHODS OF INVENTORY VALUATION
The only thing certain with respect to price normally is that they are not certain. This makes it necessary to evolve a strategy for charging the .cost of materials sold. Two of the most commonly used systems are the 'First in, First out' (FIFO) which assumes that the sales are made in the order in which they are purchased and 'Last in, First out' (LIFO), which assumes that goods which are bought last are sold first.
This could be illustrated with a simple example.
This could be illustrated with a simple example.
| | | No. of Units | Cost per Unit | Amount |
| | | | Rs. | Rs. |
| January 1 | Inventory | 500 | 3 | 1,500 |
| January 5 | Purchases | 1,000 | 4 | 4,000 |
| January 10 | Purchases | 2,000 | 5 | 10,000 |
| January 15 | Purchases | 1,000 | 6 | 6,000 |
| January 20 | Purchases | 3,000 | 4 | 12,000 |
| January 25 | Purchases | 2,000 | 7 | 14,000 |
| | Total | 9,500 | | 47,500 |
| | | Units | • | |
| January 1 1 | Sales | 1,000 | | |
| January 14 | Sales | 500 | *• | |
| January 16 | Sales | 1,000 | | |
| January 21 | Sales | 2,000 | | |
| January 30 | Sales | 1,500 | | |
| | Total | 6,000 | | |
If we value the cost of sales on the basis of FIFO we have the following situation:
Cost of goods sold and inventory under FIFO
| Date Quantity Sold | Quantity Break-up | Rate Amount | Total Amount |
| January 11 1000 | 500 500 | x3 1,500 x4 2,000 | 3,500 |
| January 14 500 | 500 | x4 2,000 | 2,000 |
| January 16 1000 | 1,000 | x5 5,000 | 5,000 |
| January 21 2,000 | 1,000 1,000 | x5 5,000 x6 6,000 | 11,000 |
| January 30 1,500 | 1,500 | x4 6,000 | 6,000 |
| Total Sales 6,000 | | | 27,500 |
| Inventory 3,500 | 1,500 2,000 | x4 6,000 , x7 14,000 | 20,000 |
| Total 9,500 | | | 47,500 |
| Thus, cost of goods sold and inventory FIFO are: Cost of goods sold 27,500 Inventory 20,000 | | | |
| Total 47,500 | | | |
| Thus cost of goods sold and inventory under FIFO are: Cost of goods sold 27,500 Inventory 20;000 47,500 If we follow LIFO the picture will be as follows Cost of goods sold and inventory under LIFO | |||
| Date Quantity | Quantity Rate | Amount | Total |
| January 1 1 1 ,000 | 1000 x5 | 5,000 | 5,000 |
| January 14 500 | 500 x5 | 2,500 | 2,500 |
| January 16 1,000 | 1,000 x6 | 6,000 | 6,000 |
| January 21 2,000 | 2,000 x4 | 8,000 | 8,000 |
| January 30 1,500 | 1,500 x7 | 10,500 | 10,500 |
| Total Sales 6,000 | | | 32,000 |
| Inventory 3,500 | 500 x3 1,000 x4 500 x5 1,000 x4 500 x7 | 1,500 4,000 2,500 4,000 3,500 | 15,500 |
| Total 9,500 | | | 47,500 |
| |
Thus, cost of goods sold and inventory under LIFO are:
Rs.
Cost of goods sold 32,000
Inventory______________________________ 15,500__________________
Total______________________________ 47,500______________
From the example above we find that the FIFO cost of goods sold, which is based on price of inventory procured earliest prior to sales, would amount to Rs. 27,500. And the closing inventory of 3,500 units will be valued at Rs. 20,000, which is based on the most current purchase prices. The LIFO cost of goods sold, which is based on the most recent prices of the inventory purchase, is Rs. 32,.000. Closing inventory, based on the prices of earlier purchase, is valued at Rs. 15,500. In both cases inventory plus cost of goods sold amount to the same, that is, Rs. 47,500 since it is based on actual historical cost only.
Here again, over the entire life of the entity there will be no difference, irrespective of the method used in valuing the cost of goods sold. There will also be no difference if the entire inventory is sold. The differences again reflect one of the effects of accounting periods on income measurement.
Posts
