Welcome to lesson 12 of business accounting and today we will look at inventory valuation and then we will look at different methods. The first one will be the first in first out method and as you can see it's abbreviated as FIFO, first in first out. Now before we go to any calculations let's see what is inventory valuation if we talk about inventory valuation what are we talking about so we are saying it's the cost associated with inventory you will remember inventory is those goods that you buy in order to resell again the cost is the price that you paid for it and then we are saying it's as calculated at the end of the reporting period You will remember in Business Accounting 1A, reporting period were normally a year.
So when we talk about the reporting period, remember it's a specific period. Now, inventory valuation forms part of the cost of sales calculation. You will also remember last semester, we said that sales, less cost of sales was your gross profit. and you will remember how we calculated the cost of sales.
Now cost of sales and cost of goods sold are the same. Then where will you show your inventory? We will show it as a current asset in the balance sheet.
You will remember the new name for balance sheet is the statement of financial position. Why is it a current asset? Because it's something that you own and you want to sell it again. So it's a current asset.
current asset. All right. So we are saying it's the cost to acquire. So it's the purchase price and the conversion cost to get it to a final product, to get it ready for sale and have it transported to a proper place to sell. But so you can include all of these costs in your valuation, but you can never include.
your selling and your admin costs. These can never be included in your inventory valuation. Now, what can we include? We can include direct labor, direct material, manufacturing overheads. You will remember manufacturing overheads or your indirect labor and indirect materials.
All right, manufacturing overheads then. You can include your handling charges. If you order it from somewhere, you will have to pay handling charges.
If you import from another country, there will be import duties. That is a kind of a tax. And then also your freight charges or your delivery charges. Those will all be included in your inventory valuation.
Now this is just an icebreaker to get you to inventory and how we are going to do the calculations. Now I'm buying 10 cool drinks and then I sell 4 cool drinks and then I buy 5 more and I sell 7 more. How many cool drinks do I have left? We can quickly do that.
I have 10 less 4, now I have 6. Then I buy another 5. now I have 11 and then I sell 7 so now I have 4. So this was easy so I can easily tell how many cool drinks I have left but now it becomes a bit more tricky when you need to calculate the cost of these cool drinks because it could be that you bought those 10 cool drinks at $1 and the 5 cool drinks at $2. So immediately, what is the cost now? So this is what we will be doing in this lesson.
This is the same exercise. How many cool drinks do I have left? We said I have four cool drinks. What is the cost of these cool drinks that I have left? So what is the value of my closing stock?
How will I do this? Because I bought some cool drinks at $1 each and then I bought some more at $1. $2 each.
Now for now, don't worry about the selling prices. Ignore those for now. So we have now a $1 cool drink.
We have a $2 cool drink. So now we need to determine which cool drinks that we sell to determine the cost of sales and which cool drinks are left to determine the closing stock. So if we use the first in first out method, then we will say that I will sell the ones that I bought first.
So at the end of the year I should have in my store my closing stock should consist of the most recent purchases. So we have basically three methods. We have the first in first out which is saying the stock that I bought first will be sold first.
All right then we have last in first out. and we are saying we will first sell the new stock and then only later the old stock but this is not really relevant in our time so we won't be doing this so this one basically fell away then we have a weighted average cost so with this one we will calculate the average cost This is a very basic example. We are saying the raw materials used in the production process are the oldest material. So the oldest material, the ones that we ordered first, we will use them first in the production process. And we call this first in, first out.
All right. So now I'm saying on the 1st of August, I bought six units. And the 15th.
I bought another five and on the 20th I sold five. So my question now is which units did I sell? Did I sell these five or did I sell five of these six?
So let me draw this and I will say this is the first of August and I had six. So there's my six units. All right, and now on the 15th of August, I bought five more.
There's my five. And now I'm saying on the 20th of August, I'm selling five units. We are saying we will sell the oldest material or we will use the oldest material first.
All right, it's five units. And now you will agree that I will take five. from this batch so the ones that i will sell is the one that was worth one dollar each so i will write there the sold items the cost was one dollar each all right there's another example once again and we can quickly draw this one also remember In a test or exam, you don't need to draw this.
It's only for me to explain it. Maybe it's better to understand or easier to understand. All right. So I have the 1st of August. I had six units.
There's my six units. All right. And then on the 15th, I bought another five. There's my five. And now I'm selling 10 units.
Which ones am I selling? Am I selling the ones that I bought on the 15th or am I selling the ones that I bought on the 1st? I'm using FIFO, first in, first out.
So I will sell the ones that I bought first. So let me start there. 1, 2, 3, 4, 5, 6. Then I need 4 units more because I'm selling 10. So it's 1, 2, 3. four. So I sold six of the first batch and then I sold four of the second batch.
So what I have left is only, let me just write it there, I only have one unit left at the end and it was the ones that I bought on the 15th. This is another example. We can quickly go through this one.
We had in the month of July, there's my dates. I'm telling you we had an opening stock and this is the movement sales purchases. This is my units. Whenever you see I'm indicating my units in bracket it means sales and this is the cost price of the units. Now for now just ignore the selling prices.
We will only work with the units and the cost then. All right so the question that we have is how many chocolate drinks are left and what are the costs of these drinks. So we will do it one step at a time and I will then draw the ones that we had. Now remember in exam or test you don't need to draw this.
This is only for me to explain. So I have then 10 units. Let me just draw it there.
There's my 10 units. And each one costed $7. So I have $7 times 10 equals $70. So this is what I have after the 1st of July. Now on the 4th, we sell.
seven units. So the only units that we had is the ones that I bought for $7. So now we are going to sell seven of these units.
So let me just take them out. One, two, three, four, five, six, seven. All right. So what is my closing now? My closing at this stage is then three units times $7 and that equals $21.
All right. What was the value or the cost of the ones that you sold? The cost price of the ones that you sold was $7.
So let me quickly draw the ones that we had left. We had the $7 units left and we had three of them. That was 7 times 3 equals 21. All right.
And now on the 4th or rather on the 10th, we are going to purchase 8 units more. So let me draw the 8. 1. two three four five six seven eight so these ones was eight dollar and it was eight units and eight times eight equals then um 64 yes so my total stock is now 21 plus 64 so it's 85 dollar this is the now my total stock. How did I get the 85? It was my three units that I had left and then the new ones that I bought. Coming to the 22nd, this is the stock that I had and now on the 22nd I will sell four units.
Remember I will start to sell the oldest ones first. So I will then take those ones so there's three all right so those stock is now gone all right and then i need one more because i'm selling four so one of these so now one of these is gone also um sorry for that let me just write it out so one of the eight dollar stock is now sold. So what do I have left?
I then have my 64 less 8. So now I have $56 in stock left. How many units do I have? I have now 1, 2, 3, 4, 5, 6, 7. And that is, we can just test our answer.
We have 7 units at $8 each equals 56. So now we are on the 28th. And on the 28th, we are selling two more units. We only have these units left. So now it's becoming easier. So I'm selling two.
What do I have left? So it's 2 times 8 that I'm selling. And that equals $16.
All right. So what do I have left? Now I have $40 left. This is my closing. We can test our answer.
We have, let me see, 1, 2, 3, 4, 5 of $8. We have $8 units times 5. and that will give you 40. so you will see each time you just add the new units when you sell you start to sell the old units and now the last one is when we will purchase 10 more units and now the cost is increasing to nine dollars so on the 30th we uh 30th we are purchasing 10 units more and now we are paying nine dollars so we can't add to this block because this block was the eight dollar unit so now we will just draw a new block so there's my new block and we are purchasing 10 and these were nine dollars so let me add them there all right so we have 10 times nine dollar you and that will give me then 90 dollar i had the 40 dollar so my total is then $130. So I think by now you get the hang of the story how to do a first in first out calculation. Always start with the units that you bought first and then as you use the units either in the production process or if you sell the units you start with a oldest ones and then you continue to the new ones. Now what are the advantages to use this method?
And the first one is because you are selling the first stock first and use the first stock first there won't be so much waste. What I mean or what I refer to if I refer to waste I'm saying that the old stock may expire or you will need to throw it away and maybe there may be spoilage. So when you are selling or using the old stock first you won't have the same waste as if you are selling the new stock first and you sit with an old stock.
Then another reason it's relatively easy to calculate and then the value of your closing stock will reflect the current market price and normally in your financial statements you will find that it's more accurate because you will use the genuine cost amounts the genuine cost figures while if we are using the average method then the cost that we will have in the financial statements will not be the genuine cost Now what are the disadvantages? In times of inflation you will know that inflation is when prices are going up, then lower cost is reported and that will increase my profit and when I have an increased profit I will have to pay more tax. Remember if my cost is lower my profit will be higher my tax will be higher.
While if I use the average valuation method maybe, then my cost will be a bit higher, my profit will be lower and my tax will be lower. Now also a disadvantage if you frequent buy new items, high volumes and it's at different prices, then this method can get tricky. So it's not proper. or the best to use with high volumes of purchases at different prices.
And then this one goes hand in hand with that one. And I'm saying that my production cost can be understated because I'm using the lower cost prices. So it could be that my production cost is then understated.
Now, this is all you need to know about the first in first out method. You must know what it's meant. What do we mean by first in first out?
You must know the advantages and you must know the disadvantages. And then, of course, the calculations. Now, when we look at the calculations, you must be able to calculate the cost of goods sold.
So the cost of sales. of the goods sold and you must also be able to calculate the value of your closing inventory.