In this two-part article we are going to look at inventory valuation, specifically focusing on:
- How to recognise which inventory method an organisation is using
- How to calculate the new closing inventory balance when the method has changed
- What the effects are on reported profits under each of the three different methods when purchase prices are changing
At advanced level, this area of management accounting builds on the fundamental understanding of raw materials, and how they are controlled and can be valued as part of a manufacturing process, covered at foundation level.
There is a three part series that reviews the theory behind inventory valuation.
It considers the characteristics of the three common methods available methods, FIFO, LIFO and AVCO and uses each of them to calculate the cost of issues and the value of closing inventory.
If you are a little rusty in this area it would provide a useful re-cap.
The foundation series is based on an example of a toaster manufacturer, so we’re going to stick with that for context and look at the inventory record for raw material AGT4, which is a spring:
There is no indication of which inventory valuation is being used so our first challenge is to work it out.
That involves a little detective work based on our knowledge and understanding of how each of the three common methods value issues to production:
- First in First Out (FIFO) – at the price paid for the oldest inventory
- Last in First Out (LIFO) – at the most recent price paid
- Average Cost (AVCO) – at the average cost of the all the inventory held at the time of the issue
We need to calculate the costs of an issue for each method and see which fits our record.
For AVCO we can calculate the cost per unit and for LIFO and FIFO we need to calculate the total cost. If we look at the issue on the 31st May for 50 units:
Using AVCO they would have been issued at £14.635 per unit (£1,083 ÷ 74 units) so it’s not that.
Using LIFO they would have been issued at a total cost of £735:
Again it doesn’t fit. Therefore, logically the manufacturer must be using FIFO but let’s just check to be sure:
Now we have a match!
This kind of investigative approach is also needed if we are required to calculate the new closing inventory balance when the valuation method changes.
In this case, we now know FIFO is being used and the inventory record shows that the 24 springs left in stores at the end of the month are valued at £354. But what would their value be if the method changed to LIFO or AVCO?
Again we need to apply our knowledge and understanding of all three inventory valuation methods, this time focusing on how each values closing inventory:
- First in First Out (FIFO) – at the most recent price paid
- Last in First Out (LIFO) – at the price paid for the oldest inventory
- Average Cost (AVCO) – at the average cost of the all the inventory held
Firstly, we know that the quantities will remain the same as the original record. We also know, due to the assumptions each methods makes about the order issues are made in, that each method will give a different closing inventory value.
Therefore if AVCO were utilised the 24 units would be valued at £351.25.
This is because the issue on 31st May would have been valued at £731.75 (50 units x £14.635) and whilst the balance of inventory remaining is an average figure, it is always calculated by deducting the quantity and value of the issue from the previous balance, to avoid rounding discrepancies.
So, £1,083 – £731.75 = £351.25.
However, if the method had been changed to LIFO the closing inventory would be valued at £345, which is a combination of the prices paid for the oldest inventory held:
In part 2 we have a look at what the effects are on reported profits under each of the three different methods when purchase prices are changing.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.