INVENTORIES AND THEIR VALUATION
Types of inventories:
In manufacturing entities, inventory comprises raw materials, work-in-process, stores, spares and tools, and finished goods
Raw materials are purchased by manufacturing entities for consumption in the production during a period. They are treated as expenses when these are issued to production whereas those raw materials that still exist, at the end of the reporting period, are treated as current assets and are termed inventories.
Work-in-process is the inventory on which partial costs have been incurred till the period end but it is not yet finished or completed and further cost is required to complete it. For instance, for manufacturing a liter of mango juice
100% of mango pulp (raw material) has been put into process whereas the labor has worked only 50% up to the end of the reporting period. Due to this, the product is neither considered completed nor it is raw material anymore. This kind of inventory is called work-in-process and is treated as a current asset.
Finished goods are the final products that have been completed and stored in a warehouse known as a “Finished Goods Store”. The goods that have been sold to the customers are treated as the cost of sales in the financial statements whereas, the goods that have not been sold till the end of the reporting period are considered inventories.
Stores, spares, and loose tools are used in the equipment and machinery and are kept in inventory so that in case of any damage to the machinery or equipment, the production should not stop and necessary tools are available in stock to resume the production at earliest. The unused stores, spares, and loose tools at period end is treated as inventory while used stores, spares, and loose tools are charged as an expense in financial statements.
Cost of inventories:
The following table explains the cost of each type of inventory:
Inventory Cost;
The raw Material Purchase price including import duties & taxes (other than those subsequently recoverable by the entity), transport, handling, and another cost directly attributable to the purchase of goods. Trade discounts, rebates, and other similar items are deducted in determining the cost. (IAS 2)
Work-in-process Cost of raw material as determined above, plus direct labor cost and production overhead costs to the extent of work done.
Stores, spares, and tools Same as Raw Material
Finished Goods Cost of raw material as determined above, plus direct labor cost and production overheads.
Sometimes, the inventories are damaged or become wholly or partly obsolete. In such a case, the company
• Either have to incur more cost to bring them into saleable condition due to which the cost may exceed the selling price
• Or sell them in the damaged/obsoleted form for which the selling price would probably be lower than the actual cost as the demand for such obsoleted product may have come down In such cases, the company needs to bring the inventories at their net realizable value.
Net Realizable Value:
Net realizable value is the estimated selling price in the ordinary course of business less the estimated cost of completion and the estimated cost necessary to make the sale (IAS 2).
It refers to the net amount that an entity expects to realize from the sale of the inventory in the ordinary course of business (IAS 2).
Valuation of Inventory:
An entity is required to evaluate, at the end of each reporting period, the net realizable value of its inventories and value the inventories at lower of:
• Cost or
• Net realizable value
The cost of the inventories is ordinarily lower than the net realizable value. Therefore, the inventories are carried at their costs. However, the cost may exceed the net realizable value in the following cases:
• The inventories are damaged,
• The inventories have become wholly or partially obsolete,
• The selling price of the inventories have declined, or
• The estimated cost of completion or estimated cost to be incurred to make the sale have increased (IAS 2).
The historical cost of inventory is usually measured by one of the following methods:
• First in, first out (FIFO)
• Weighted average cost (AVCO)
The FIFO and weighted average cost (AVCO) methods of inventory valuation are used within perpetual inventory systems. They can also be used to establish a cost for closing inventory with the period-end inventory system.
First-in, first-out method of valuation (FIFO)
With the first-in, first-out method of inventory valuation, cost of inventory consumed is strictly based in the order of purchase means first purchase is issued first and so on. In simple words, the first items that are received into inventory are the first items that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:
• the date that units of inventory are received into inventory, the number of units received and their purchase price (or manufacturing cost)
• the date that units are issued from inventory and the number of units issued.
With this information, it is possible to put a cost to the inventory that is issued (sold or used) and to identify the cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units that are used, it follows that the value of inventory at any time should be the cost of the most recently-acquired units of inventory.
Weighted average cost (AVCO) method
With the weighted average cost (AVCO) method of inventory valuation it is assumed that all units are issued at the current weighted average cost per unit.
The normal method of measuring average cost is the perpetual basis method. With the perpetual basis AVCO method, a new average cost is calculated whenever more items are purchased and received into store. It is also termed as running weighted average method, as at new purchase with different price will change the average cost of inventory. The weighted average cost is calculated by using the following formula:
Formula:
Average cost:
Cost of inventory currently in store + Cost of new items received
Number of units currently in store + Number of new units received
Advantages & Disadvantages of FIFO
Advantages
• This method is realistic and in line with the physical movement of goods normally.
• Easy to understand and explain to managers
• Gives a value near to replacement cost
Disadvantages
• Can be cumbersome to operate especially when frequent purchase is made and prices are fluctuating on regular basis
• Managers may find it difficult to compare costs and make decisions when they are charged with varying prices for the same materials
• In a period of high inflation, inventory issue prices will lag behind current market value
Advantages & Disadvantages of AVCO
Advantages
• Smoothens out price fluctuations as different prices are converted into average prices.
• Easier to administer than FIFO Disadvantages
• Issue price is rarely what has been paid
• Prices tend to lag a little behind current market values when there is gradual inflation
Journal Entries
Following journal entries are related to movement of raw material inventory under perpetual inventory system.
Description ; Journal Entry
When raw material is purchased
Material Inventory Dr.
Accounts Payable Cr.
When raw material is issued to production
Work in process Dr. (Direct material)
Factory overhead control Dr. (Indirect material)
Material Inventory Cr.
When raw material is returned to vendor
Accounts Payable Dr.
Material Inventory Cr.
When raw material is returned from production to store
Material Inventory Dr.
Work in process Cr. (Direct material)
Factory overhead control Cr. (Indirect material)
Recording of loss of raw material inventory (Shortage)
Factory overhead control Dr.
Material Inventory Cr.
Recording of inventory at NRV if cost exceeds NRV at period end
Factory overhead control Dr.
Material Inventory Cr.
(With difference of cost and NRV)
Assumed Journal Entries on basis of AVCO method of costing are given below:
5 April Raw material 18,000
Account payable 18,000
(Cost of material purchased)
9 May Work in process 11,500
Raw material 11,500
(Issue of raw material to production)
14 July Raw material 35,000
Account payable 35,000
(Cost of material purchased)
25 July Work in process 13,286
Raw material 13,286
(Issue of raw material to production)
22 October Raw material 16,000
Account payable 16,000
(Cost of material purchased)
23 November Work in process 14,061
Raw material 14,061
(Issue of raw material to production)
22 December Work in process 14,061
Raw material 14,061
(Issue of raw material to production)
0 Comments