INVENTORY VALUATION METHODS IN INDIAN …SPJIMR Mumbai Email: [email protected] ... the SME for inventory valuation to evaluate the appropriateness of the method to the industrial

Volume 6, Issue 12 (December, 2017) UGC APPROVED Online ISSN-2277-1166

1 Available online on www.abhinavjournal.com

Published by: Abhinav Publication

Abhinav National Monthly Refereed Journal of Research in Commerce & Management

INVENTORY VALUATION METHODS IN INDIAN MANUFACTURING SECTOR SMES - AN EMPIRICAL STUDY

Lakshminarayanan Latha Assistant Professor (Adjunct)

SPJIMR Mumbai

Email: [email protected]

ABSTRACT

A review of economic activity across the world in the past two decades reveals that the contribution of

the SMEs towards economic growth of a country has been steadily increasing in terms of its

contribution towards GDP, employment opportunity and exports. Adopting well-structured and

appropriate practices in their manufacturing operations and accounting and control functions will

enable the Indian SMEs in the manufacturing sector to achieve sustained growth and profitability. An

important activity in the control function is inventory valuation. Inventory consumed in the production

process amounts to greater than 50% of the total cost of the product. Hence inventory valuation is a

topic of significant relevance to SMEs in the manufacturing sector. Furthermore, with the onset of

GST, their current practices will not be sustainable from legal and regulatory point of view. With this

background, this Study aims at (a) ascertaining the existing Inventory Valuation Methods in Indian

SMEs in the manufacturing sector. (b )comparing the ideal method with the method currently used by

the SME for inventory valuation to evaluate the appropriateness of the method to the industrial sector

the SME belongs to. This Study has been conducted through structured interviews preceded by a

Survey Questionnaire which was administered to 100 respondents selected through purposive

sampling. The Study finds that majority of the respondents irrespective of the industry they were

operating in, applied the FIFO method of inventory valuation. It concludes that majority of the

respondents do not use inventory valuation method appropriate to the industry in which they operate.

Keywords: inventory, valuation, SMEs, manufacturing

INTRODUCTION

According to International Federation of Accountants (IFAC, 1998), Cost Management function also

known as Management Accounting function has four major roles to play in a business organisation

which are given below in the order as it evolved as part of evolution of Management Accounting

1. Cost determination and financial control.

2. Providing information for Management planning and control.

3. Reduction of waste of business resources

4. Creation of value through effective use of resources. This four roles and how each one has led to

the next one is nicely encapsulated by IFAC in Fig 1 given below.

Inventory forms a major part of costs in the manufacturing sector. Hence, recording of external and

internal transactions of inventory correctly for (a) determining costs,(b) planning and decision making

relating to inventory, (c) pricing of finished products,(d) determining accurate profit for a specific

financial period.

Abhinav National Monthly Refereed Journal of Research In

Commerce & Management

2 VOL. 6, ISSUE 12 (December, 2017) Online ISSN 2277-1166

Inventory Valuation is an important part of both cost determination and financial control and this paper

aims to study this important aspect with reference to the SMEs in the Indian Manufacturing sector.

DEFINITION OF SME

In India, a manufacturing enterprise with investment in plant and machinery less than or equal to Rs.10

crore is defined as an SME, as per SME Chamber of India. (http ://www.smechamberofindia.com)

This plant and machinery could be either owned by the SME or rented/leased by the SME. As per a

report titled “SMEs’ Role in Indian Manufacturing sector” (www.ibef.org) and an article in the

Economic Times, (Venkatachalam, 2012) , there are about 48 million SMEs in the Indian

Manufacturing Sector. This article also mentions that the SMEs contribute significantly to the Indian

economy. Their contribution to industrial output is 45%, 42 million to employment, 40% share of total

exports and 17% to the GDP of India with more than 7500 quality products. For a manufacturing

sector enterprise, raw material costs and Direct Labour costs constitute up to 70% to 80% of their total

cost.

MEANING OF INVENTORY

In the manufacturing Sector, Inventory is of three types: Inventory of Raw Material, Inventory of

Work-in-progress or semi-finished goods, and inventory of finished goods. Ind AS 2 describes in brief

the treatment of inventories in reporting the financial statements. When inventories are sold, the

carrying amount of those inventories shall be recognised as an expense in the period in which the

related revenue is recognised. The amount of any write-down of inventories to net realisable value and

all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs.

The amount of any reversal of any write-down of inventories, arising from an increase in net realisable

value, shall be recognised as a reduction in the amount of inventories recognised as an expense in the

period in which the reversal occurs. Recognition of Inventory value for calculating the cost of goods

sold as an expense has a direct impact on the profit before tax of the period. This incorrect value of the

closing inventory of this period, becomes the opening stock of the next period. Thus the error in

inventory valuation affects not only the profits of the current period, but also of the following period.

Hence, inventory valuation is a very critical activity and function of the cost and management

accounting function in the manufacturing sector.

The study has been done based on the inventory valuation methods of 100 SMEs in the manufacturing

sector. These 100 SMEs have been selected from 29 industrial sectors and are geographically from pan

India. The study has collected data based on structured interviews aided by a Survey Questionnaire

which was administered to these SMEs with questions relating to Inventory Valuation. The study

attempts to compare the correct inventory valuation method vis a vis the current valuation method

being followed by these SMEs based on the researcher’s academic interaction with the SMEs and a

decade of experience in the corporate sector dealing with SME vendors in the manufacturing sector.

LITERATURE REVIEW

Since the study covered the topic of Inventory Valuation methods, it was necessary to review the

extant literature on the subject and the same has been covered in this section. An existing study of Cost

Management Systems and Practices in SMEs undertaken in UK, Japan, Malaysia, provide insights on

the significance of cost information for managerial decisions and measuring business performance.

The study covered the areas of inventory control, costing concepts and accounting information systems

(Edison, Manuere and Joseph, 2012) and the findings indicated that cost benefit analysis, lack of

government support, financial constraints, complexity of Accounting Information Systems .strongly

influence non adoption of AISs by SMEs. A study (Ngubane, Mayekiao, et al, 2015 ) on a similar

topic found that although majority of the respondent SMEs were aware of formal inventory

management systems, they did not extensively make use of them but ironically the informal inventory

management systems which were used by these respondents, were found to be working for them.

Another study (Hall and McPeak, 2011)., indicates that the SMEs tend to be cash flow-strapped

because of inventory in the supply chain -both outbound and inbound, suffer from extended accounts




receivables, often as a result of retailers taking advantage of their small size. Another study examined

a case of the lock manufacturing industry in the Aligarh district, Uttar Pradesh. The investigations

revealed that lock manufacturing units, by-and-large, were either unaware of even the fundamental

techniques of inventory management or did not practice them for one reason or the other. (Farooquie

and Khan, 2010). An attempt to ascertain the role and importance of inventory management practices

and performance of SMEs in the machine tool industry in the city of Bangalore, brings out the fact that

formal inventory management practices have a positive impact on the inventory cost and therefore, the

performance of SMEs.(Narayana Pillai,2010).

The review of literature above reveals that some studies have been done in the area of Inventory

Control and optimizing inventory costs. However there is no empirical paper available on the

Inventory valuation methods used by Indian SMEs in the manufacturing sector. This paper is an

attempt to address this gap.

RESEARCH OBJECTIVES The following are the research objectives of this paper:

1. Ascertaining the existing Inventory Valuation Methods in Indian SMEs in the manufacturing

sector.

2. Comparing the ideal method with the method used by the SME for inventory valuation to

evaluate the appropriateness of the method to the industrial sector the SME belongs to.

RESEARCH QUESTIONS

The study aims to address the following two Research Questions:

1. What inventory valuation methods are the SME respondent firms currently using in their

business?

2. Is the method they use appropriate with respect to the ideal method used as per the concepts of

Inventory valuation for the SMEs’ industrial sector?

RESEARCH METHODOLOGY

This section covers the methodology of research undertaken for this Study, a brief description of

which has been given below.

RESEARCH DESIGN

This Study uses the Qualitative method of research. Structured interviews, (face to face or telephonic,

depending on geographical location), were held with the respondents with specific questions regarding

their Inventory valuation methods. The interviews were aided by a Survey Questionnaire, which was

administered to the respondents in advance of the interviews. The questions were aimed at getting

primary data, viz. inventory valuation methods used by the respondent SMEs. The topic of inventory

valuation is associated with costs and such data is treated to be confidential by these SMEs. Hence

there is very little information in the public domain on this topic and so no secondary data could be

used for this study.

SAMPLING METHOD AND SAMPLE SIZE

The scenario for the sample selection was complicated due to the target population size for the study.

Indian economy has a large contribution from the SMEs. The number of SMEs in the manufacturing

sector is about 48.6 million. A random sampling of this huge population would not be economically

feasible for the researcher. Moreover,the research title deals with inventory management or valuation

comes under the area of “Cost” and “Costing Systems” generally considered confidential and internal

information by most business firms whether large scale or SMEs. Hence, Purposive Sampling method

was used for selecting the sample respondents.

The sample size has been worked out using 95% confidence level and an error margin of +/-10%. The

sample size calculator available in the url: https://www.surveysystem.com/sscalc.htm has been used

for this calculation and a snapshot of the output window is posted below:




Based on the above, the sample size chosen for this Study was 96, rounded off to 100 to facilitate Data

Analysis.

DATA ANALYSIS

The analysis of data has been covered in two parts:

RESPONSE ANALYSIS

The process of data collection for this Study was by means of the responses received from the

respondents during the structured interviews conducted with the aid of the Survey Questionnaire. The

selected respondents were from pan India geographically and also covered a diverse range of industries

in the manufacturing sector

Table 1 below gives the diverse sectors which this study covered whereas Table 2 covers the

geographical diversity of the respondents.

Table 1 List of Industries covered in this Study

SECTOR NO. OF RESPONDENTS

Agricultural Equipment 1

Beverage 3

Cables & Wires 4

Cement 2

Chemicals 2

Cigarettes, Bidis 1

Construction Material 2

Consumer Durables 2

Cosmetics 1

Dairy 1

Electrical Equipment 2

Food Industry 4

Forgings 1

Furniture 2

Household décor 2

Iron & Steel products 12

Jewellery 2

Lighting & Luminaires 1

Mfg Equipments & Parts 18

Non Ferrous Products 2

Oil & Lubricants 1

Paper - Packaging & other

applications

5




Table 2: Geographical Diversity of the respondent SMEs

Central Total 11 South Total 16

Bhopal 1 Bangalore 6

Indore 5 Belgaum 1

Nagpur 2 Chennai 3

Ratlam 1 Coimbatore 1

Shivpuri [MP] 1 Hyderabad 1

Neemuch [MP] 1 Madurai 1

North Total 18 Nuzvid [AP] 1

Ahmedabad 3 Tirupur 2

Ankleshwar 1 West Total 49

Baroda 2 Ahmedabad 1

Delhi 2 Halol-Gujrat 1

Faridabad 2 Mumbai 33

Gujarat 1 Nanded 1

Jaipur 3 Nashik 3

Kanpur 1 Navi Mumbai 1

NOIDA 1 Pune 4

Rajkot 1 Sangli 1

Silvassa 1 Surat 1

East Total 6 Thane 3

Kolkatta 4

Total 100 Siliguri 1

Sundergarh, Orissa 1

ANALYSIS OF INVENTORY VALUATION METHODS

As per Ind AS 2, the widely used Inventory Valuation Methods in businesses are FIFO, LIFO,

Weighted Average Method, Simple Average method and a brief description is given below:

The FIFO Method: The FIFO formula assumes that the items of inventory that were purchased or

produced first are sold first, and consequently the items remaining in inventory at the end of the period

are those most recently purchased or produced.

The LIFO Method: Under the LIFO method the inventory that were purchased or produced recently

are sold first and those items that are left in the inventory are those purchased the earliest.

Perfumes 1

Pharmaceuticals 7

Plastic 10

Power Distribution

Equipment

2

Rubber products 2

Textiles 6

Toys 1

TOTAL 100




The Weighted Average Method: Under the weighted average cost formula, the cost of each item is

determined from the weighted average of the cost of similar items at the beginning of a period and the

cost of similar items purchased or produced during the period. The average may be calculated on a

periodic basis, or as each additional shipment is received, depending upon the circumstances of the

entity.

Based on the responses received from the Survey, Table 3 below gives the data about the method of

inventory valuation used by the respondents. The data shows that 62% of the respondents use the

FIFO method.

Table 3 Types of inventory valuation methods used by Respondent SMEs

Type FIFO LIFO Wtd. Avg Others*

Percentage of

Respondents

62 4 27 7

*Actual cost. Simple Average

Every industry based on its typical nature of production and products, has an ideal inventory valuation

method. For example in the iron and steel industry, FIFO is best suited because the oldest stock has to

be sold out first, else there will be loss of material owing to rusting of inventory. SMEs may not be

using the ideal method of inventory valuation suited to their industry owing to lack of awareness and

continue using traditional systems handed over to them from the previous generation owners. This

study has reviewed the current inventory valuation of the firm and commented on whether the

valuation system used by the respondents is appropriate to the ideal method. This comparative

evaluation has been presented in the Table 4 below. Analysis of the data from the table shows that

65% of the firms use an Inventory Valuation method different from the view of the researcher.

Table 4: Researcher’s Comparative Evaluation on the methods used by each respondent

Sr.

No.

Product

Manufactured

Inventory

Valuation

Method

Researcher's comments *Logical , means the Researcher agrees to the

respondent firm’s method for inventory valuation.

1

Steel

Processing(Decoil

ing, slitting and

Blanking of steel

coils)

FIFO

FIFO will reflect reality, if the firm is operating on

bare minimum inventory; If it has high amount of

RM, then Wtd. average will be more closer to reality

2 Pharma [API] FIFO FIFO has to be followed, as it is expected to be

consumed physically as FIFO. Hence Logical.*

3

SS kitchen

equipment and

bakery equipment

FIFO

Being a discrete manufacturing process, stock levels

are supposed to be lower and physically used by

FIFO. Hence, Logical

4 Fashion[Pure Silk

Fabrics] FIFO Logical

5 Pneumatic Tools FIFO Logical




6

High voltage

Elec.Equipments,

Grid automation,

Reactors,Transfor

mers,Line

Traps,Capacitor

Banks,SVCs,….

FIFO

One to one tracking is appropriate as it is more of a

project industry. FIFO can be a reasonable

approximation

7

Bulletproof

Equipments for

Defence &

Elec.Insulation for

Power & Railway

sector

Wtd.Avg. Logical

8 Granite slabs,

Tiles &Artefacts FIFO Logical

9

Consumer

durables[Mixer

Grinder, Food

Processors, Juicer

mixer,etc.

Wtd.Avg.



RM, then Wtd. average will be more closer to reality.

10 Pre Cast Concrete

Products Wtd.Avg.

Logical

11 Mattress FIFO Logical

12

Plastic household

products and

packaging

Wtd.Avg. Logical

13 Industrial Valves Wtd.Avg.


project industry which is a B2B industry. Hence,

FIFO can be a reasonable approximation

14

Pre Anodized

Aluminium

Coils/Sheets for

the lighting

industry.

FIFO




15 Colour Melange &

Fancy Yarns Wtd.Avg.




16 Kraft Paper FIFO




17 Polishing

Compounds FIFO




18 Auto parts FIFO Logical




19 Agricultural Eq. &

spares Wtd.Avg.

For Equipment FIFO is closer to reality and if possible

one to one tracking; For spares Wtd average is logical

20 Chemicals and

Veterninery drugs. FIFO

FIFO will reflect reality, if we are hand to mouth; If I

have high amount of RM, then Wtd average may be

more closer to reality

21

Pharmaceutical

Bulk drug and API

mfg.

Wtd.Avg. FIFO has to be followed, as it is expected to be

consumed physically as FIFO

22 Precision Turned

Components FIFO Logical

23 Plastic pipes and

fittings Average



RM, then Wtd. average will be more closer to reality

24 Laboratory

Testing equipment LIFO

Lab Testing Equipment have shelf life. Hence FIFO is

more appropriate

25

Household

consumer goods

Wtd.Avg.

FIFO to be followed

26 Furniture

components LIFO Wtd. average will be appropriate

27 Industrial Heaters FIFO Logical

28 Bearings & Auto

components FIFO Logical

29 Clay Tiles LIFO Logical

30 Electrical engg.

Switchgear FIFO

For Equipment ,FIFO is closer to reality and if

possible one to one tracking; For spares Wtd average

is logical

31

Material Handling

systems, Process

automation for

biscuit and

confectionery

industry.

FIFO

For Equipment, FIFO is closer to reality and if

possible one to one tracking; For spares, Wtd.

average is logical

32 Herbal Extracts FIFO

FIFO, if physical FIFO is followed; Otherwise Wtd

average (especially if the stock levels are high) If

inputs have shelf life, FIFO is closer to reality

33 Diamond

Polishing Wtd.Avg. Logical

34 Corrugated boxes FIFO Wtd Average is more appropriate

35 Ferrous Castings FIFO

FIFO, if physical FIFO is followed; Otherwise

Wtdaverage (especially if the stock level are high) If

inputs have shelf life, FIFO is closer to reality.




36

Flexible

Multilayer

laminates for

Electrical

insulation, Cable

Wraps and Solar

Photovoltic

Backsheets.

Wtd.Avg. Logical

37 Rigid PVC Pipes Wtd.Avg. Logical

38 Cement Wtd.Avg. Logical

39 Plastic Stationery Wtd.Avg. Logical

40 Plastic pipes and

fittings Average

Wtd Average is more appropriate, as it also takes into

account the Quantity of the material while calculating

the rate.

41 Pharma IV fluids. FIFO Logical

42

Precision

Mchinery parts &

Locomotive

Components

FIFO Logical

43

MS Pipes & Tubes

used in hydraulic

systems, fuel

injections,m/c

mfg,etc.

FIFO

If the products are standard products , then FIFO is

Logical . However if the product is made-to-order and

customized then physical tracking one to one is

possible on FIFO basis.

44 Not Available FIFO

45

EPC Process

Equipments,

Reactors, Heat

Exchangers,

Pressure Vessels,

Storage Tanks,

Structural

Fabrication&Erect

ion

Wtd.Avg. FIFO or one to one tracking is more logical

46 Energy Meters FIFO Logical

47 Steel Wires FIFO Logical (or if the stock levels are high - Wtd average)

48 Printing &

Packaging FIFO Logical (or if the stock levels are high - Wtd average)

49

Herbal products

for skin care, oral

care and hair care

FIFO

These products have a shelf life. Hence FIFO is

appropriate. However if stock levels are high then wtd

average is more appropriate.

50 Stainless Steel

Fasteners Wtd.Avg. Logical

51 Speciality Tea Bags FIFO Logical




52 Empty hard

capsules FIFO Logical

53 Fabrication FIFO Logical (or if the stock levels are high - Wtd average)

54 Yarn FIFO Logical

55 Food ingredients,

nutraceuticals Wtd.Avg.

FIFO is more closer to ground reality, unless the stock

levels are very high

56 Anti Vibration

Mounts FIFO Logical

57

Transformers &

control relay

panels

FIFO Logical

58

Sheet metal

fabrication &

Light fixtures

FIFO Logical (or if the stock levels are high - Wtd average)

59 Corrugated boxes FIFO Logical (or if the stock levels are high - Wtd average)

60 Sweets and

Snacks FIFO Logical (or if the stock levels are high - Wtd average)

61 Furnishings and

Upholstery FIFO Wtd Average is more appropriate

62 Dairy Wtd.Avg. FIFO is more closer to ground reality, unless the stock

levels are very high

63

Liquid Ring

Vacuum Pumps,

Centrifugal

blowers, Arial

flow fans.

FIFO Logical

64 Printed Cartons FIFO Logical (or if the stock levels are high - Wtd average)

65 Iron&Steel FIFO

FIFO will reflect reality, if the firm operates on bare

minimum inventory; If the firm has high amount of

RM, then Wtd average may be more closer to reality

66

Gold and

Diamond

Jewellery

LIFO Wtd Average is more appropriate

67 Shirts,Trousers,Su

its for MEN Wtd.Avg. FIFO is closer to reality

68

Rubber Products

for Oil & Gas

Industry.

Wtd.Avg. Logical

69 Teas

Net

Realisable

Value

Logical (but NRV or cost which ever is lesser)

70 Perfumes FIFO Logical (or if the stock levels are high - Wtd average)




71 PP/HDPE Woven

sacks,Jumbo bags. FIFO Logical (or if the stock levels are high - Wtd average)

72 kids' cycles FIFO Logical

73 Forgings,Fittings,

Valves

Actual

Cost

Wrong method. Tracking inventory values in this

industry at Actual cost is not possible. Wtd average is

more appropriate

74 Wool felt and Felt

Products

Actual

Cost Wrong method. FIFO is more appropriate

75 Mfg. Blow wheels

for motor industry Wtd.Avg. Logical

76

Components for

Automotive &

Electronics

Industry


77 Food products Wtd.Avg. FIFO is closer to reality

78

Customised

engineering

equipments and

spares

Wtd.Avg. FIFO or one to one tracking is more logical

79

Engineering spare

parts and

components

Just in

Time

Just in time is not an inventory valuation method. It is

an inventory control method. Wtd.average is more

appropriate for this firm.

80 I&Steel(TMT

bars, Wire Rods) Wtd.Avg.




81 Alloy Steel Billets

& rolled products FIFO




82 Mild Steel Wires FIFO




83 Plastic bags FIFO




84 Ice Blocks FIFO Logical

85 Rubber Products. FIFO




86 Cables FIFO




87

Electrical panels,

transformers &

Enclosures

FIFO

Logical




88 Teas FIFO Logical

89 BIOFUEL

(Chemical) Wtd. Avg.




90 Bidis&Hand made

cigarettes Wtd. Avg.




91 Furniture FIFO Logical (or if the stock levels are high - Wtd average)

92

Lubricating Oil,

Specialty Oil,

Greases


93

Machinery for

Pulp,Paper&board

. Individual

equipments&Turn

key projects

FIFO FIFO or one to one tracking is more logical

94 Jari FIFO




95 Special Purpose

Machines

Project

based


project industry. FIFO can be a reasonable

approximation

96 Plastic Household

goods FIFO




97

Aluminium &

Plastic caps for

Pharmaceutical

companies

Wtd. Avg.




98 Steel Wires FIFO




99 Brass & Copper

Sheets FIFO




100 Plastic

components FIFO




FINDINGS AND LIMITATION

FINDINGS

1. 62% of the firms use FIFO method whether relevant or not. They use this method

because they are able to maintain records in simple Microsoft excel formats. Out of these

62% , 15% do use local ERP systems, yet have built in their systems, the FIFO method

because they are able to understand it faster and better and can verify the calculations

with a calculator. 4% use LIFO method, 27% use Weighted Average method and the

balance 7% use other methods such as Actual Cost, Simple Average cost, etc.




2. Based on the questions asked during the face to face interviews with the respondent

firms, it was found that 73% of the firms do not know the significance of the

mathematical relationship between PBT and its closing Inventory Value. As long as they

are making a profit they are not concerned about the method used for inventory valuation.

3. 65% of the firms use an Inventory Valuation method different from the view of the

researcher.

LIMITATIONS

The study could not tap the data of the unregistered SMEs in this sector.

CONCLUSION

Inventory valuation is an important parameter in the cost management function of a firm. An

incorrect inventory valuation method will lead to incorrect profit reporting. The use of

incorrect inventory values for inventory control activities and decisions will lead to high risks

for the SMEs in terms of their sales plan, pricing decisions and future profits. More over

SMEs who have taken working capital loans will have to justify to their bankers, in case such

incorrect inventory values are noticed by them during periodic reviews. Also wrong profit

reporting in the firm’s profit / loss account on account of wrong inventory valuation method

can be tracked by Income Tax authorities during tax audits for the firms who may classify it

as non-compliance.

Also, the owner-managers of the SMEs who follow wrong inventory valuation methods will

find it difficult to take optimal decisions relating to their operations like purchase planning,

sales planning and production planning. Every business decision which requires inventory

value as a piece of critical decision making will be affected due to the incorrect inventory

valuation.

This Study concludes that majority of SMEs in the manufacturing sector, are not following the

method ideally suited to the industry in which the SME firm is operating in. This is due to

lack of awareness of impact of inventory valuation method on the profit of the firm. This issue

can be addressed by organisations like MSME and other industrial associations, by organizing

training programmes, specially for SMEs, on inventory valuation methods and their impact on

business performance.

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INVENTORY VALUATION METHODS IN INDIAN …SPJIMR Mumbai Email: [email protected] ... the SME for inventory valuation to evaluate the appropriateness of the method to the industrial