Management accounting is a fundamental part of your AAT studies at levels 2, 3 and 4, so First Intuition tutor Gareth John is going to give you some tips on dealing with one of the more technical areas you will encounter: Inventory valuation.
A particularly important item that we need to value is the current asset of inventory, or stock as it is sometimes known. This is a figure that we need to get right since inventory is included on both the profit & loss account and the balance sheet so an error would affect both net profit and net assets.
One important aspect of valuing inventory is keeping track of the movement of units of stock.
Inventory valuation methods
There are three different ways to view the movements of inventory into and out of our store room. These are:
- First in, first out (or FIFO)
- Last in, first out (or LIFO)
- Average cost (AVCO)
In your AAT studies you need to be able to calculate values using all three of these methods.
A little scenario
Let’s say we have a very simple business buying and selling apples, and that we have had a rather quiet month with the following three transactions:
1 January – bought (or purchased) one apple for 50p
5 January – bought a second apple for 60p
10 January – sold (or issued) one apple at a price of 90p
The two figures we are interested in working out are:
- the “cost of the issue” – which would allow us to work out the profit on the sale made on 10 January
- the “value of the remaining inventory” at the end of the period – since we bought two apples and sold one there must be one apple that is left in the store room at the end of January.
Let’s look at how each of these two figures work under each of the three inventory valuation methods.
A lot of businesses will sell their oldest units of inventory first, particularly for items that may spoil as they get older such as food. Under FIFO, the “first in” (the oldest unit) is the “first out”, meaning that we would assume that on 10 January we were selling the apple bought on 1 January, the one that cost 50p.
Since the “cost of the issue” is 50p we have made a profit on the sale of 90p – 50p = 40p and the “value of the remaining inventory” is 60p, being the apple bought on 5 January.
Under LIFO, the “last in” (the newest unit) is the “first out”, meaning that we would assume we were selling the apple bought on 5 January, the one that cost 60p.
Since the “cost of the issue” is now 60p we have made a profit on the sale of 90p – 60p = 30p and the “value of the remaining inventory” is 50p, being the apple bought on 1 January.
What if when we make the sale on 10 December we can’t remember which of the two apples in the store room is which. Under AVCO we take the average cost of the inventory held at the time of the sale. This is the average of the two apples bought giving (50p + 60p)/2 = 55p average cost per apple. We assume that both of the two apples in the store room have this average cost.
Since the “cost of the issue” is now 55p we have made a profit on the sale of 90p – 55p = 35p and the “value of the remaining inventory” is 55p.
Have a go yourself
Here is a slightly more complex example for you to consider:
A business buys and sells bananas, and has had the following three transactions:
1 January – bought 20 bananas for 20p each
5 January – bought 30 bananas for 30p each
10 January – sold 40 bananas
Work out the “cost of the issue” and the “value of remaining inventory” under each of the three inventory valuation methods.
Gareth John is a qualified chartered accountant and tutor at First Intuition.