Lecture 8

Inventory Valuation

Learning Objectives:
You should be able to:
Describe what perpetual and periodic inventories
are
Calculate the value of inventory using FIFO basis
Calculate the value of inventory using AVCO basis
Describe the merits & defects of each method

Importance of Inventory
Valuation
Value of inventory determines cost of sales &
therefore gross profit.
It also affects working capital in the Statement
of Financial Position.
Why do firms hold stocks?
Transactions motive-to meet production & sales
requirements.
Precautionary motive-supply of raw materials
may be unreliable.
Speculative motive-to speculate on the expected
increase or decrease in future prices.

Definitions
Inventories include:
- Goods or other assets purchased
for resale
- Raw materials and components
purchased for incorporation into
products for sale
- Products & services in intermediate
stages for completion work in
progress
- Finished goods

Definition
Cost :Expenditure which has been
incurred in the normal course of
business in bringing the
inventory to its present location
and condition

Cost
Cost of conversion comprises
a)
costs which are specifically attributable
to units of production
b)
production overheads
c)
other overheads, if applicable
Production overheads:
Overheads incurred in respect of
materials, labour or services for
production, based on the normal level of
activity
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Perpetual & Periodic Inventories

Stock/inventory
- a record of goods received by, and
used or sold by, a business
Perpetual inventory
- maintains a running balance of
stock-in-hand after each transaction
Periodic inventory
- shows the balance of stock-on-hand
only at intervals
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Methods of Valuing
Inventories

FIFO First In, First Out

AVCO Weighted average cost

FIFO

Inventories are assumed to be used

in the order in which they were
received from the supplier
Inventories-in-hand represents the
LATEST purchases or production
The first items to be received are
the first to be issued

AVCO
o

The weighted average cost of

inventory is calculated every time
new goods are received
Inventory is valued at the weighted
average cost calculated

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Example
Date

Details

Units

Unit cost

2005
Jan 1

Balance b/f

100

$
8

Feb 7

Purchases

400

10

Jun 3

Sales

300

Aug 8

Purchases

500

12

Oct 2

Sales

400

Nov 5

Sales

100

Dec 8

Purchases

200

13
11

Periodic Inventory - FIFO

Closing inventory value on 31 Dec
2005:
Most recent purchases (Dec 8)
200 units @ $13 - $2 600
Next preceding purchase (Aug 8)
200 units @ $12 - $2 400
$5 000
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Perpetual Inventory - FIFO method

Date
Received
Issued
Jan 1
Feb 7 400 @ $10
Jun 3

100 @ $8
800
100 @ $8
800
400 @ $10 4000 4800
100 @ $8
200 @ $10

Aug 8 500 @ $12

Oct 2

Nov 5
Dec 8 200 @ $13

Stock after each

transaction

200 @ $10 2000

200 @ $10 2000
500 @ $12 6000 8000

200 @ $10
200 @ $12

300 @ $12 3600

100 @ $12

200 @ $12 2400

200 @ $12 2400
200 @ $13 2600 5000
13

Periodic Inventory - AVCO

Weighted average unit cost
= cost of opening inventory + cost of purchases
No. of units available for sale
= $800 + $12 600
1200
=
$11 .17
Closing stock value on 31 December 2005
= 400 units x $11.17
= $4 468

14

Perpetual Inventory - AVCO

Date
Received
Issued
Jan 1
Feb 7

Aug 8

100 @ $8 800
500 @ $9.60
4800

400 @ $10

Jun 3

Stock after each transaction

300 @ $9.60

500 @ $12

200 @ $9.60

1920

700 @ $11.314 7920

Oct 2

400 @ $11.314

300 @ $11.314

3394

Nov 5

100 @ $11.314

200 @ $11.314

2263

400 @ $12.16

4863

Dec 8

200 @ $13

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FIFO - Advantages

Simple to use
A realistic system
Prices used to value inventories are prices actually
paid
Closing inventories are valued on current price
levels
In times of rising prices, closing inventories will be
valued at the high prices, which results in lowering
cost of sales and increasing gross profit, thus
Statement of Comprehensive Income will look
favourable to the investors.
Recommended under MFRS 102 and IAS 2.

16

FIFO - Disadvantages

Businesses unable to fix realistic

selling price
Problems occur when identical stocks
from batches bought at different
times are used for similar jobs.
In times of rising prices, closing
inventories will be valued at the high
prices, which results in lowering cost
of sales and increasing gross profit,
which will lead to higher tax burden.
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AVCO - Advantages

Avoids the inequality of identical

items charged to different jobs at
different prices.
It smoothes variations in production
costs, and comparisons of results
more meaningful.
Acceptable under MFRS 102 and
IAS 2.

18

AVCO - Disadvantages

An average price must be recalculated after every purchase of

stock.
The average price does not
represent any price actually paid for
stock.

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Factors Affecting Stock Valuation

Ignorance
Convenience
Custom
Taxation
Motivated by borrowing
Motivated to sell co at higher price
Remunerations
Lack of info
Advice of the auditors
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