Business Accounting Lesson 12: Inventory Valuation

Overview

• Focus: Inventory Valuation and Methods
• Key method: First In, First Out (FIFO)

What is Inventory Valuation?

• Definition: Cost associated with inventory
• Inventory: Goods bought for resale
• Valuation at the end of the reporting period (usually a year)
• Part of Cost of Sales calculation
• Cost of Sales = Sales - Cost of Sales = Gross Profit
• Inventory shown as a current asset on the balance sheet (Statement of Financial Position)

Cost Components in Inventory Valuation

• Included Costs:
  • Direct labor
  • Direct materials
  • Manufacturing overheads (indirect labor and materials)
  • Handling charges
  • Import duties
  • Freight/delivery charges
• Excluded Costs:
  • Selling costs
  • Administrative costs

Example Calculation

• Scenario:
  • Buy 10 cool drinks, sell 4, buy 5 more, sell 7
  • Remaining: 4 cool drinks
• Cost Analysis:
  • Initial purchase: 10 at $1 each
  • Second purchase: 5 at $2 each
  • Determine the cost of remaining stock using FIFO

FIFO Method Explained

• FIFO Principle:
  • Sell oldest inventory first
  • Closing stock consists of most recent purchases
• Alternative Methods:
  • Last In, First Out (LIFO)
  • Weighted Average Cost

Detailed Example Using FIFO

1. August 1: Buy 6 units

2. August 15: Buy 5 more units

3. August 20: Sell 5 units

   • Sold: 5 from the first batch (cost $1 each)

4. New Scenario:

   • Sell 10 units on August 15
   • Sold: 6 from first batch (cost $1 each) and 4 from second batch (cost $2 each)
   • Remaining: 1 unit from second batch

Summary of Sales and Purchases

• Example with sales on various dates and their costs
• Tracking stock:
  • Opening stock, sales, purchases
  • Closing stock calculations using FIFO

Advantages of FIFO Method

• Reduces waste by selling older stock first
• Easier calculations
• Reflects current market prices in closing stock value
• More accurate financial statements with genuine cost figures

Disadvantages of FIFO Method

• In inflationary times:
  • Lower costs reported
  • Increased profit and tax implications
• Frequent purchases at different prices complicate calculations
• Potential understatement of production costs

Key Takeaways

• Understand FIFO method: definition, advantages, and disadvantages
• Ability to calculate Cost of Goods Sold and value of closing inventory using FIFO
• Importance of accurately tracking inventory for financial statements and tax purposes.