In this two-part article we are looking 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
We covered the first two points in part one so will conclude by bringing together aspects of both financial and management accounting theory to look at how inventory valuation effects reported reports.
In previous articles we have alluded to the relationship that exists between the costing and financial accounting systems within organisations.
Inventory management and valuation is an area where they overlap because both systems use the same costs but in different ways and for different purposes.
Ultimately they work together and one example of that is when closing inventory is valued at year-end and the overall figure included in the financial statements.
In the last article we calculated the value of closing inventory for AGT4 under each of the three methods and the results were:
- FIFO – £354
- AVCO – £351.25
- LIFO – £345
We can see FIFO is the highest, LIFO the lowest and AVCO in the middle.
This is absolutely typical of what we would expect, in circumstances where prices are increasing, due to the assumptions each methods makes about the order in which issues are made.
We can confirm by checking the inventory record that prices have increased:
Therefore, we would expect issues made using FIFO to have the lowest total cost of the three methods and those issued under LIFO the highest.
When we review the total costs of the issue on the 31st May, from the last article, the results match this expectation:
- LIFO – £735
- AVCO – £731.75
- FIFO – £729
In summary, when prices are increasing, we can expect:
- FIFO to issue at the lowest total cost and therefore have the highest closing inventory value
- LIFO to be the opposite, issuing at the highest total cost which results in the lowest closing inventory value
- AVCO to give costs and values in the middle
It is important to grasp this key area and to be clear that these expectations only apply when prices are rising. That said, if you understand one method then you can apply your knowledge to the other methods, which is a better approach than trying to remember everything verbatim.
Equally, the same approach works if we need to think about what happens when prices fall. AVCO will still hold the middle ground. But FIFO and LIFO will switch, with FIFO then issuing at the highest total cost which would results in the lowest closing inventory value, and LIFO being the opposite.
Now we can predict how each method will value closing inventory in relation to each other and to price changes, we can look at what effect that has on reported profits.
Gross profit is simply the difference between the selling price of a product and the cost of that sale and it’s usually calculated in the top section of the statement of profit of loss (SoPL).
Financial accounting principles and standards require the cost of sales calculation to take opening and closing inventory into account along with purchases. It is in the cost of goods sold (COGS) calculation that the valuation of closing inventory, based on either LIFO, FIFO or AVCO, is included.
Let’s put our closing inventory into a SoPL extract that has been analysed to show the effect of each method on profits*
You can see the all the figures are the same for each method until we get to the closing inventory.
The highest closing inventory results in the lowest COGS figure, which then produces the highest profit figure.
When prices increase, this is the result we would expect; FIFO returning the highest profit figure, LIFO the lowest and AVCO in the middle. Logically then, if prices fall we would expect to see this pattern reversed.
Therefore, it is important to be mindful of which way purchase prices are changing and not just assume that they are going up.
That said, it is more likely that over time price will increase instead of decrease, even if they do fluctuate on the way.
It is because of this generally assumed upward trend and its resultant effect to reduce profit, that LIFO is excluded under IAS2 as an inventory valuation method that can be used in the production of financial statements.
* Note, I have made up a sales price of £20 per unit just to illustrate the example.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.