Inventory Valuation

Inventory constitutes an important current asset that significantly impacts business profitability. Inventory valuation is done to ascertain the costs associated with goods sold. It is also done to ascertain the value of goods unsold, lying in storage.

Meaning of inventory valuation

Inventory valuation is a method of assessing the worth of unsold inventory when a company prepares its financial statements. It must be valued appropriately at the end of the reporting period, such as the financial year which can be easily done if you have inventory management software. The valued inventory will then form a part of the financial statements. Ind AS-2 and AS-2 provide the accounting treatment for inventories, especially with regard to their measurement and disclosure.

Importance of inventory valuation

• Determining the financial position of the business

Inventories form part of both the statement of profit and loss as well as the balance sheet. Therefore, the valuation must be done accurately, failing to reflect an incorrect financial position.

• Determining the gross profit

When matched with direct revenue earned, the Cost of Goods Sold (COGS) will help you arrive at the gross profit. The formula for calculating gross profit first requires you to find out the cost of goods sold. 

COGS = Opening stock + Purchases + Direct Expenses – Closing Stock

Once this is arrived at, it is compared with sales, and the difference amount is either gross profit or gross loss. If the opening or closing stock is overstated or understated, it directly affects the net income calculations. Therefore, the valuation of inventory has to be appropriate and accurate.

• Liquidity analysis

Inventory forms a large part of the working capital. Since inventory is a current asset, it is not meant to be held for a long period. Inventory is used to determine the liquidity levels of the company. The stock turnover ratio, particularly, has to be on the higher side. 

• Statutory compliance

As per the AS-2 and Ind AS-2  (valuation of inventories) guidelines, the company must disclose the following information regarding inventories-

• Accounting policies used in the measurement
• Carrying amount of inventories
• Inventory to be recognised as expense
• Inventory write-down and reversal of write-down

Methods of inventory valuation in use

There are common methods used for the valuation of inventories-

• FIFO

FIFO stands for First In First Out. Under this method, the oldest inventory is first sold off. The first manufactured or purchased inventory will be the first one on the way out in the form of sales. Retailers in the business commonly use it. Whenever you go to a supermarket or a general store, you will find that the oldest products will be out front, and the newer ones will be positioned at the back of the shelf.

• LIFO

LIFO stands for Last In First Out. As opposed to FIFO, where the oldest inventory is sold first, the most recent items purchased or manufactured will be the first ones sold under this valuation method. Automobile dealerships normally opt for this as they try to move on the newer model vehicles at the earliest, taking advantage of the initial public interest.

• Weighted Average Cost

Closing stock and the cost of goods sold here is arrived at by calculating the same using the average cost of the items purchased. Manufacturing businesses tend to opt for this valuation method since it is difficult for them to distinguish between batches. For instance, in the coffee industry, where coffee beans are roasted, one batch may be mixed with the previous batch.

How to calculate inventory?

Item (Football)	Units	Rate per unit
June	50	40
July	150	35
August	200	30
Items purchased	400
Items sold	220
Items unsold	80

The value of purchases amounts to Rs.13,250 (50*40 + 150*35 + 200*30)

The value of inventory will be calculated under the three methods as follows-

(1) FIFO

Items bought first will be sold first. The value of sales is Rs.7,850 (50*40 + 150*35 + 20*30). Therefore, closing stock amounts to Rs.13,250 – Rs.7,850 = Rs.5,400.

(2) LIFO

Items bought last will be sold first. The value of sales is Rs.6,700 (200*30 + 20*35)

Therefore, closing stock amounts to Rs.13,250 – Rs.6,700 = Rs.6,550.

(3) Weighted Average Cost

The total value of purchases is divided by the total number of units to get the average cost.

Therefore, average cost = Rs.13,250 ÷ 400 = Rs.33.13.

Sales = Rs.33.13 * 220 = Rs.7,289.

Therefore, closing stock = Rs.13,250 – Rs.7,289 = Rs.5,961.