Level 2 exam tips: Introduction to costing

“♬ FIFO, LIFO, it’s off to work AVCO ♬” is the song that Brainy, the accounting Dwarf, cheerfully sings as he’s on his way to work with his six colleagues.  He’s feeling Happy because he knows the secrets of inventory valuation. Unfortunately though, until we’ve had some practice, some of us can appear a little Dopey when it comes to the calculations.

Inventory or stock is vital for many businesses; their success may depend upon their ability to supply the right goods, at the right price and at the right time.

In various sectors, the availability of stock will be given the highest priority, therefore many companies may lean towards keeping their inventory levels on the high side. As such, it is no surprise that Inventory may actually be the largest asset on their Statement of Financial Position. Despite this, the ‘true’ cost of holding inventory can be easily overlooked, as may be the importance of applying the appropriate method of valuing the stock.

Carrying inventory is expensive. Capital may be tied up. Not to mention storage space, the security issues involved and the depletion of perishable goods.

Efficient inventory control is a delicate balancing act as a company will face conflicting demands on its resources. The application of an appropriate value to the inventory is a major part of this function as it can make a significant difference to the value of the ‘asset’ and how the fortunes of the company are reflected in its Financial Statements.

Luckily for AAT Students we start to cover this in Level 2, Introduction to Costing, where we compare the three main types of inventory valuation, First in First Out (FIFO), Last in First Out (LIFO) and, Average Costing (AVCO).

It’s fairly straightforward to visualise these valuation methods although each one has its advantages and disadvantages.

For FIFO, imagine perishable goods. You need to get the oldest produce out of the warehouse onto the shelves before the sell by date so it makes sense to issue the oldest first. The first inventory in is the first inventory out, although its value on issue may be less than the market value of the most recent inventory purchases.

LIFO is the opposite to FIFO. The last or most recent goods brought into the warehouse are the first ones out to be issued. Imagine that the oldest inventory sits right at the back of the warehouse. If your inventory is inert, e.g. coal or limestone, it will not perish or deplete over time so it really wouldn’t matter if you issued it from the front or the back. Here the value of the inventory issued will be at the most recent market value but, importantly, the value of the remaining inventory which may have been purchased at a much lower price may give a false representation of its value in today’s terms.

AVCO  ascertains the mean average cost of the inventory as a whole and issues the goods at that average cost. Every time new inventory is purchased a revaluation to calculate the average cost of the inventory is carried out. Future issues are made at that cost until more stock is purchased and the cycle starts again, continually averaging out the overall value of the stock.

At Level 2, as well as identifying some of the advantages and disadvantages of each method, you will be expected to calculate and compare the three different options from the information provided to you in the task.

A typical task may inform you that a company has the various movements in a certain type of inventory into and out of its stores for the month of May:

Date

Receipts

Issues

 

Units

Cost

Units

Cost

May 5 1,200 £1,440
May 10 1,800 £2,520
May 12 1,000 £1,600
May 15 1,500 £?
May 28 1,000 £1,800

Your assignment is to complete the table below for the issue and closing inventory values to the nearest £:

Method

Value of Issue 15 May £

Inventory at 31 May £

FIFO

?

?

LIFO

?

?

AVCO

?

?

The key to this task is to calculate the value of each unit purchased before any inventory is issued.

Date

Receipts

 

Units

Cost

May 5 1,200 £1,440 £1,440/1200 = £1.20 per Unit
May 10 1,800 £2,520 £2,520/1800 = £1.40 per Unit
May 12 1,000 £1,600 £1,600/1200 = £1.60 per Unit

We are told that 1,500 units are issued on 15th May, we now have to calculate the cost of these issues under the three methods of valuation.

FIFO

UNITS

 

£

1,200 @ £1.20 1,200 @ 1.20 £1,440 The oldest of ‘first’ inventory purchased May 5
   300 @ £1.40    300 @ 1.40 £   420 Part of the next oldest inventory purchase May 10
Total Units Issued 1,500 £1,860 Cost of issues under FIFO method

 

LIFO

UNITS

 

£

1,000 @ £1.60 1,000 @ 1.60 £1,600 The latest or ‘last’ inventory purchased May 12
  500 @ £1.40    500 @ 1.40 £   700 Part of next most recent inventory purchased May 10
Total Units Issued 1,500 £2,300 Cost of issues under LIFO method

 

AVCO

UNITS

 

£

1,200 £1,440 Inventory purchased May 5
1,800 £2,520 Inventory purchased May 10
1,000 AVERAGE UNIT COST £1,600 Inventory purchased May 12
4,000 £5,560/4000 = £1.39 £5,560 Total Value / Units = Average Unit Cost
Total Units Issued 1,500 @ 1.39 £2,085 Cost of issues under AVCO method

You can now see the differences in the value of the issues, FIFO giving the lowest cost of issue, LIFO the highest and AVCO sitting between the two.

Method

Value of Issue 15 May £

FIFO

£1,860

LIFO

£2,300

AVCO

£2,085

We can now calculate the value of the closing inventory under each method as at the 31st May.

Firstly complete a simple addition of all the values of the purchases in the period. Remember, it’s the closing inventory value at the 31st May we are seeking so we have to include the units purchased on 28th May, even though they came in after the issue of inventory on the 15th.

Receipt

 Cost £

May 5

£1,440

May 10

£2,520

May 12

£1,600

May 28

£1,800

Total

£7,360

We then can then simply subtract the value of the issues under each method from the total cost of the units purchased up to May 31 which completes the task.

Method

Value of Issue 15 May £

Inventory at 31 May £

FIFO

£1,860

£7,360 – £1,860 = £5,500

LIFO

£2,300

£7,360 – £2,300 = £5,060

AVCO

£2,085

£7,360 – £2,085 = £5,275

The difference in inventory valuation methods can influence profit levels in the Income Statement due to its reflection in the cost of sales. It also has the potential to make a substantial impression on the value of assets on the Statement of Financial Position. Our example has illustrated a difference of hundreds of pounds but add a few noughts on to the end and we could be talking millions!

Russell Hague an AAT tutor at Sheffield City College and works as a Finance Manager for a small group of companie.

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