Study tips : Valuation of raw materials – part 2

In this three part series we’re going to review valuation of raw materials for the AAT Foundation Certificate. 

Study Tips: Valuation of raw materials series

• part 1
• part 2
• part 3

In part one of this series on inventory valuation methods, we reviewed why and how raw materials are processed and controlled as part of the manufacturing process.  

We also looked at the characteristics of the three common methods available. Having covered the theory, we’re now going to put it into practice and calculate the cost of issues and the value of closing inventory using FIFO, LIFO and AVCO.

Let’s return to the inventory record for raw material SSt14, which you may remember are sheets of stainless steel, and assume the records show that the 5,000 in stores were all bought at the same time:

Now let’s update the record with details from a purchase order:

At this point it doesn’t matter which inventory valuation method is being used as the details of receipts are entered in the same way for all three methods.

Note that the cost per unit is shown to three decimal places.   Also note that if you needed to, you could work out any of the three figures as long as you know two of them.   In other words, the total cost is the quantity multiplied by the cost per unit, but that can be reversed to calculate the cost per unit, by dividing the total cost by the quantity or to calculate the quantity, by dividing the total cost by the cost per unit.

Now we’ve updated the record for a receipt let’s look at how to deal with an issue of 500 sheets to production.  

FIFO

Under FIFO we value the issue based on the price paid for the oldest inventory.  In this case that’s the 5,000 sheets that are valued at £112,500. So, we start by calculating the cost per unit (£112,500 ÷ 5,000 = £22.50) then multiply the cost by unit by the quantity to calculate the total cost of the issue:

The balance of inventory remaining is valued at the most recent price paid. It is updated by deducting the quantity of the issue from the latest balance (10,000 – 500 = 9,500) and the value of the issue from the latest total cost (£231,275 – £11,250 = £220,025).  

These figures can be double checked as they should equal the quantity and value left from each purchase:

LIFO

When we’re using LIFO though, we value issues to production at the most recent price paid.  

This time it’s the 5,000 sheets that were purchased on 7^th April.  Therefore we can enter the quantity and cost per unit then multiply them to calculate the total cost of the issue:

The balance of inventory remaining is valued at the price paid for the oldest inventory but is updated by the same method as FIFO.  

Again the figures can be double checked as they should equal the quantity and value left from each purchase, only this time we are working in reverse date order or from the bottom up:

AVCO

Finally, if we work the issue again using AVCO, we value issues to production at the average cost of all the inventory held at the time of the issue.  

That means calculating the average cost per unit as at 7^th April (£231,275 ÷ 10,000 = £23.128) rounded to three decimal places** and multiplying by the quantity to calculate the value of the issue on 10^th April:

The balance of inventory remaining is an average figure but should always be calculated by deducting the quantity and value of the issue from the previous balance as per FIFO and LIFO.  

This is because if the cost per unit has been rounded discrepancies can occur. Our case is a good example because the balance of 9,500 would be valued at £219,716 if the cost per unit of the issue (£23.128) was used in the calculation and that would be incorrect.

Changing your valuation method

In part one, we said that organisations can choose either of the three methods for cost accounting purposes. Let’s say our toaster manufacturer uses AVCO currently but is thinking about changing to one of the others.

Here’s the inventory record for some plastic trim which is another raw material it uses.  The cost per metre is shown to three decimal places but the total cost rounded to whole numbers:

In order to work out what the cost of the issue and the closing inventory balance would be if FIFO or LIFO had be used instead, we need to apply our knowledge and understanding of all three inventory valuation methods. Firstly, we know that the quantities must remain the same as the original AVCO 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 result.  If prices have increased, as they usually do, the FIFO issue value is going to be lowest of the three and the LIFO issue the highest.

This is useful to know as it enables us to check that our figures fit our expectations. Using the same theory, it is therefore logical that we should expect the lowest closing value from LIFO and the highest from FIFO.

So what are they really?

Using FIFO the cost of the issue would be £725 and the closing inventory value £186:

Using LIFO the cost of the issue would be £733 and the closing inventory value £178:

In the final part of this series we’ll have a look at how the valuation of raw materials fits into the bigger picture of cost accounting and is used to calculate the total costs of products and their cost per unit.

* Note that the rounding of 4,500 units @ £23.755 per unit has led to a £1 discrepancy between the record, which is correct, and the check, which is acceptable as we know the reason for the difference.

** The need to round figures is common with AVCO so care should be taken to comply with any policies over the number of decimal places required.

Read part 3 of this series next.

Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.