4.3 Measurement of Inventories

Inventory is normally measured at its historical cost， at which the inventory was originally bought． The only time when historical cost is not used is when cost needs to be reduced to net realisable value． Net realisable value （ NRV） is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale． In other words， net realisable value is the expected selling price， less any costs still to be incurred in getting the inventory ready for sale． IAS 2 states that inventory should be stated at the lower of cost and NRV， as we will see below． This is an important rule and one which you should learn by heart．

1.Applying the Lower of Cost and NRV

If a business has many inventory items on hand， the comparison of cost and NRV should theoretically be carried out for each item separately． It is not sufficient to compare the total cost of all inventory items with their total NRV． An example will show why．

Suppose a company has four items of inventory on hand at the end of its accounting period．Their cost and NRVs are shown in Exhibit 4.3.

It would be incorrect to compare total costs （￡ 113） with total NRV （￡ 135） and to state inventories at ￡ 113 in the statement of financial position． The company can foresee a loss of ￡ 6 on item 2 and this should be recognised． If the four items are taken together in total， the loss on item 2 is masked by the anticipated profits on the other items． By performing the cost and NRV comparison for each item separately the prudent valuation of ￡ 107 can be derived． This is the value which should appear in the statement of financial position．

However， for a company with large amounts of inventory， this procedure may be impracticable． In this case it is acceptable to group similar items into categories and perform the comparison of cost and NRV category by category， rather than item by item．

Worked Example 4.3

The following figures in Exhibit 4.4 relate to inventory held at the year end．

Requirement

Calculate the value of inventory for inclusion in the financial statements．

Solution

The comparison of cost and NRV for each item is shown in Exhibit 4.5.

So have we now solved the problem of how a business should value its inventories？ It seems that all the business has to do is choose the lower of cost and NRV． This is true as far as it goes， but there is one further problem， perhaps not so easy to foresee： for a given type of inventory， what was the cost ？

2.Determining the Cost of Inventory

IAS 2 states cost of inventories should include all：

·Costs of purchases．

·Costs of conversion．

·Other costs incurred in bringing the inventories to their present location and condition．

Cost of purchase includes ：The purchase price， import duties and other non-recoverable taxes， transport， handling and other costs directly attributable to the acquisition of finished goods and materials．

Cost of conversion includes ： Any costs involved in converting raw materials into final product， including labour， expenses directly related to the product and an appropriate share of production overheads （but not sales， administrative or general overheads）．

Other costs ：Any other costs should only be recognised if they are incurred in bringing the inventories to their present location and condition ．

In other words，the total cost of an item of inventory includes all costs of purchase， of conversion and of other in bringing the items to their saleable condition．

Worked Example 4.4

A business has the following details relating to production and sales for a reporting period：

Sales： 900 units at ￡ 600 each

1，000 units are produced with the following costs being incurred：

Opening inventory of raw materials： 200 units at ￡ 100 each

Purchases of raw materials： 1，050 units at ￡ 100 each

Closing inventory of raw materials： 250 units at ￡ 100 each

Production wages： ￡ 150，000

Production overheads： ￡ 100，000

General administration， selling and distribution costs： ￡ 100，000

Requirement

Calculate the cost of production and net profit．

Solution

The cost of production should include an appropriate share of production wages and production overheads ，but not non-production expenses ．Exhibit 4.6 shows the calculation．

The cost of production is spread over the units produced． Any unsold units are valued at a figure that reflects a share of these costs． When the inventory is eventually sold， the production overheads associated with its manufacture will be thereby properly matched with the revenues earned．

3.Different Valuations of Inventory

A business may be continually adding items to finished goods inventory or purchasing a particular component． As each batch of goods is received from suppliers， or each finished goods batch is added to inventory， they are stored in the appropriate place， where they will be mingled with items already there． These goods are considered interchangeable in that the storekeeper would not distinguish between items when they issue items to production or to despatch． They will simply pull out the nearest item to hand， which may have arrived in the latest batch， in an earlier batch or in several different ／ batches． There are several techniques which are used in practice to attribute a cost to interchangeable inventory items； remember that actual materials，components and finished goods items can be issued in any order irrespective of when each one entered inventory．

First in， first out method （FIFO）

This is usually referred to as FIFO， from the first letters of each word． This method says that the first items to be received are the first to be issued．Using this method， we are assuming the oldest items are issued first and inventory remaining is therefore the newer items and cost is measured as such．

Average cost method （AVCO）

As purchase prices change with each new batch of goods， the average price of goods held is constantly changed． Using the AVCO method， with each receipt of goods the average cost for each item is recalculated． Further issues of goods are then at that figure， until another receipt of goods means that another recalculation is needed．

Last in， first out method （LIFO）

This is usually referred to as LIFO． As each issue of items is made， they are assumed to be from the last batch received before that date． Where there is not enough left of the last batch， then the balance needed is assumed to come from the previous batch still unsold． Using this method， inventories are stated as the oldest receipts．

If you are preparing financial statements， you would normally expect to use FIFO or AVCO for the valuation of inventory． IAS 2 Inventories does not permit the use of LIFO． Furthermore， you should remember that terms such as FIFO and AVCO refer to pricing methods only． The actual components can be used in any order． To illustrate the different methods of FIFO and AVCO， the following transactions will be used in each case．

Worked Example 4.5

Transactions during May 20×7 are shown in Exhibit 4.7.

Receipts mean goods are received into store and issues represent the issue of goods from store．

The problem is to put a valuation on the following．

（1） The issues of materials．

（2） The closing inventory．

Requirement

How would issues and closing inventory be valued using FIFO and AVCO？

Solution

（1） FIFO assumes that goods are issued out of inventory in the order in which they were delivered into inventory， i．e． issues are priced at the cost of the earliest delivery remaining in inventory．

The cost of issues and closing inventory value in the example， using FIFO， would be as shown in Exhibit 4.8.

* OI ＝Opening Inventory

Note that the cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of opening inventory （￡ 1，916）．

（2） AVCO may be used in various ways in costing inventory issues． The most common is the cumulative weighted average pricing method illustrated below．

·A weighted average cost for all units in inventory is calculated． Issues are valued at this average cost， and the balance of inventory remaining has the same unit cost．

·A new weighted average cost is calculated whenever a new delivery of goods into store is received．

In our example， issue costs and closing inventory values would be as described in Exhibit 4.9：

* A new unit cost is calculated whenever a new receipt of goods occurs．

** Whenever goods are issued， the unit value of the items issued is the current weighted average cost per unit at the time of the issue．

For this method too， the cost of goods issued plus the cost of closing inventory equals the cost of purchases plus the cost of opening inventory （￡ 1，916）．

4.Inventory Valuation and the Calculation of Profits

FIFO and AVCO each produced different costs， both of closing inventories and also of materials issues． Since raw material costs affect the cost of production， and the cost of production works through eventually into the cost of sales （ cost of goods sold）， it follows that different methods of inventory valuation will provide different profit figures ． Let's see the following example．

Worked Example 4.6

On 1 November 20×2 a company held 300 units of finished goods in inventory． These cost￡ 3，600.During November 20×2 three batches of finished goods were received into store from the production department． Please refer to Exhibit 4.10：

Finished goods sold during November were as shown in Exhibit 4.11.

Requirement

Identify the profit from selling inventory in November 20×2， applying the principles of：

（1）FIFO．

（2）AVCO （using cumulative weighted average costing）．

Ignore administration， sales and distribution costs．

Solution

（1）FIFO method calculation is shown in Exhibit 4.12.

（2 ） AVCO （ cumulative weighted average cost ） method calculation is shown in Exhibit 4.13.

Using different methods，Exhibit 4.14 describes the calculation of November's profit．

Different inventory valuations produce different cost of sales and profits figures． Here opening inventory values are the same， therefore the difference in the amount of profit under each method is the same as the difference in the valuations of closing inventory ．

The profit differences are only temporary． The opening inventory in December 20×2 will be ￡ 6，000 or ￡ 5，874， depending on the inventory valuation used． Different opening inventory values will affect the cost of sales and profits in December， so that in the long run inequalities in cost of sales each month will even themselves out． 8UPIMw072tZRrX12kqV2pm9cKQVwezauZYwccLt5f2jjseo05ic9ssoPqxIZxEk1