In this three part series we’re going to review inventory valuation.
We are specifically going to focus on raw materials and how they are controlled and can be valued as part of a manufacturing process.
The first point to make is that raw materials are one of three types of inventory. The manufacturing process starts with raw materials, which are then used to make a product that is known as work in progress/part-complete goods, until it gets to the end of the process and is then categorised as finished goods.
All three types of inventory will need to be valued at year-end in order for an overall figure for closing inventory to be included in the financial accounts. However, from a management accounting point of view, the cost of inventory needs to be managed and valued on a regular basis because it is included in the calculation of how much a product has cost to produce. This is important as it must either be controlled to enable a fixed selling price to be achieved or be marked up to determine the selling price.
Steps involved for the production process
Let’s start thinking about making a stainless steel toaster and start with the steps involved in getting the sheet of metal into the production process.
Sheets of metal are:
- purchased from suppliers
- kept in stores
- issued to production
The paperwork that accompanies this process is really important as it informs the record keeping which is used for inventory valuation.
The first step will result in a purchase invoice containing details of quantities and the cost per unit of the sheets of metal purchased.
This information is transferred into the inventory record when the delivery is received and the metal placed in stores. Finally, when some of the metal is needed for production the inventory recorded is updated, to record the issue and details of the sheets that remain.
Finally, when some of the metal is needed for production the inventory recorded is updated, to record the issue and details of the sheets that remain.
This is the inventory record for raw material SSt14, which are sheets of stainless steel:
We can see that currently 5,000 sheet are being held in stores and that their total value is £112,500. If we divide the cost by the quantity we can calculate a cost per unit of £22.50. However, we don’t know whether the balance is the result of a single or multiple orders.
If it is the latter, the cost per unit is unlikely to have remained the same for each as purchase prices usually fluctuate with market prices. So, if production now requires 500 sheets, how do we know what value to attribute to them? Do we assume they were purchased for £22.50? What if prices have increased? Should the price paid for the oldest inventory in stores be used or the most recent price paid?
The dilemma caused by fluctuations in purchases prices is the reason why we need a method to value inventory when we issue it to production.
There are three common methods to choose from:
- First in First Out (FIFO)
- Values issues to production at the price paid for the oldest inventory
- Therefore the balance of inventory remaining is valued at the most recent price paid
- Last in First Out (LIFO)
- Values issues to production at the most recent price paid
- Therefore the balance of inventory remaining is valued at the price paid for the oldest inventory
- Average Cost (AVCO)
- Values issues to production at the average cost of the all the inventory held at the time of the issue
- Therefore the balance of inventory remaining is valued as an average as well
Each method has advantages and disadvantages and each will result in different valuations. However, for cost accounting purposes, all three are equally valid and organisations are free to decide which is the most appropriate to use.*
This is because they are based on theoretical assumptions about how inventory is issued, as opposed to the reality of how inventory actually is used.
This is a key point to take on board in order to successfully grasp this area of cost accounting. For example, metal is not perishable and therefore it doesn’t matter which 500 of the 5,000 sheets in stores actually gets issued to production. However, if we were issuing 500Kg of strawberries for the production of jam, then we would actually want to issue the oldest fruit in the stores so that it doesn’t spoil.
In neither case though, are we likely to issue an average of the raw materials available. The point is, that the order in which the metal or strawberries are used in reality, is irrelevant to the assumptions made about the order in which they are issued for valuation purposes.
In part two we’ll have a look at how we put this theory into practice and see how we calculate the cost of issues and the value of closing inventory, using each of the three methods.
* Please note that under ISA2, LIFO is not an acceptable method for financial accounting purposes.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.