Our learning in the

Previous Class…

We learnt …

What costs to What costs to be included be included

in inventory?in inventory?

General Rule…

The cost of inventories should

comprise all costs of purchasecosts of purchase,

costs of conversioncosts of conversion and other other

costscosts incurred in bringing the

inventories to their present location

and condition.

COSTS OF PURCHASE…COSTS OF PURCHASE…

Cost of purchases includes all those expenses that are

incurred to bring the raw material at the desired location.

COSTS OF CONVERSIONCOSTS OF CONVERSION … It includes all those expenses that are incurred

to convert raw material into work-in-progress and finally, into finished goods. Such a cost is generally called CONVERSION COST.

Conversion Cost includes…

Direct Labour Cost

Indirect Labour Cost (Production)

Other fixed production overheads – Fixed or Variable.

COSTS OF CONVERSIONCOSTS OF CONVERSION …

Costs of Conversion do not include…•Storage Costs, unless those costs are necessary in the production process prior to a further production stage.•Administrative Overheads that do not contribute to bringing the inventories to their present location and condition.•Selling and Distribution Costs.

OTHER COSTSOTHER COSTS …

Other costs are included in the cost of

inventories only to the extent that they

are incurred in bringing the inventories to

their present location and condition.

What are What are inventory inventory systems?systems?

If we record transactions related to inventory INSTANTANEOUSLY, then we are using a System of Inventory which is known as …

PERPETUAL INVENTORY PERPETUAL INVENTORY SYSTEM SYSTEM

And, if we are recording transactions related to inventory periodically then, it is called … PERIODIC INVENTORY SYSTEM.

How to find How to find the the Value of Value of

InventoryInventory??

The issue of Inventory Valuation requires…

…an assumption about the flow of flow of

inventoryinventory so that we can judge the flow of cost of inventory!!!

COST FLOW ASSUMPTIONS …Four assumptions are made with regard to inventory cost flow:

1.Specific Identification,

2.FIFO,

3.LIFO, and

4.Average Cost.

Any question?

Now, let’s proceed further…

Inventory Cost Flow Methods

FIFO• The oldest units

are sold and the newest units remain in inventory.

• The cost of the oldest units purchased is transferred to COGS.

LIFO• The newest

units are sold and the oldest units remain in inventory.

• The cost of the most recent units purchased is transferred to COGS.

Average Cost• An average cost is

computed for all inventory available for sale during the period.

• COGS is computed by multiplying the number of units sold by the average cost per unit.

Compare Inventory Methods: General

LIFO gives a better reflection of COGS in the income statement.

Therefore, LIFO is a better measure of income.

FIFO gives a better measure of inventory on the balance sheet.

Therefore, FIFO is a better measure of inventory value.

Compare Inventory Methods – During Increasing Prices

LIFO provides a proper value of COGS in the income statement and Profits are less.

But, it provides undervaluation of inventory on Balance Sheet.

It undervalues COGS and provides MORE profit.

FIFO provides proper value of inventory in the balance sheet.

Compare Inventory Methods – During Decreasing Prices

LIFO provides lower value of COGS in the income statement and Profits are more.

But, it provides higher value of inventory on Balance Sheet.

It provides higher COGS and provides less profit.

FIFO provides lower value of inventory in the balance sheet.

Interesting Interesting things things

about about LIFOLIFO??

22

LIFO LayersAny year in which the number of units

purchased exceeds the number of units sold, a new LIFO layerLIFO layer is created in ending inventory.

The creation of LIFO layers results in ending inventory at very old prices

23

LIFO Layers Example

Year of Purchase

Number of Units

Unit Cost

Number of Units

Number of Units Unit Cost Total Cost

2004 120 Rs. 5 100 20 Rs. 5 Rs. 100

2005 150 Rs. 10 120 20 Rs. 530 Rs. 10 Rs. 400

2006 160 Rs. 15 120 20 Rs. 530 Rs. 1040 Rs. 15 Rs. 1,000

Purchases Sales Ending Inventory

20 units from 2004 + 30 units from 2005

20 units from 2004 + 30 units from 2005 + 40 units from 2006

24

LIFO Reserve

The difference between the LIFO ending inventory amount and the amount obtained using another method (e.g., FIFO or average cost)

Disclosed to aid in comparing companies that use different inventory cost flow assumptions

25

LIFO Liquidation

Occurs when the number of units purchased does not exceed the number of units sold.

The old LIFO layer costs to flow through cost of goods sold, reducing cost of goods sold and increasing net income

Other Methods Other Methods of of

Inventory Inventory ValuationValuation??

Other Methods of Inventory Valuation…

Retail Method

Gross Profit Method

Standard Cost Method

Retail MethodOccasionally used for interim period reporting.

Needed information includes:

Beginning inventory at cost and retail.

Net purchases at cost and retail.

Net sales.

Retail Inventory MethodRetail Inventory Method

Step 3 Cost to retail ratio

Ending inventory at

retail

Estimated ending

inventory at cost

=×

Step 2Goods

available for sale at retail

Goods available for sale at cost

=÷ Cost to retail ratio

Step 1 Net sales at retail

Goods available for sale at retail

– =Ending

inventory at retail

Retail Inventory MethodRetail Inventory Method

Retail Inventory MethodRetail Inventory Method

Retail Inventory MethodRetail Inventory Method

Gross Profit MethodEstimate ending inventory by applying the gross

profit ratio to net sales at retail.

Useful when inventories have been destroyed, lost or stolen.

Example:Gross Profit Method

Assume the following data:

Beginning inventory, January 1 Rs. 25,000

Purchases, January 1 through January 31 40,000

Sales, January 1 through January 31 50,000

Historical gross profit percentage 40%

Gross Profit Method

Sales (actual) Rs. 50,000 100%

Gross profit (estimate) Rs. 20,000 40%

Cost of goods sold (estimate) Rs. 30,000 60%

Beginning inventory (actual) Rs. 25,000+ Purchases (actual) 40,000= Cost of goods avail for sale (actual) 65,000

= Ending inventory (estimate) 35,000- Cost of goods sold (estimate) 30,000

Standard Cost MethodStandard costs take into account normal levels

of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions.

Under this method, the cost of goods sold/issued is calculated at the standard cost and at the end, any variance, if any, needs to be adjusted.

What are the What are the impact of impact of

ERRORS in ERRORS in Inventory Inventory

ValuationValuation??

38

Ending Inventory Errors

If ending inventory is ...

Cost of Goods Sold is ...

Profitis ...

Overstated Understated Overstated

Understated Overstated Understated

How to How to REPORT REPORT Value of Value of

InventoryInventory in in Financial Financial

StatementsStatements??

Indian Accounting Standard – AS 2

AS-2Use Specific Identification Method If Specific Identification Method is not applicable

the, then the cost of inventories can be determined through – FIFO Weighted Average Cost

When it is impractical to calculate, the following methods could be used- Standard Cost Method Retail Method

Remember,The value of Closing Inventory in the Balance Sheet is always to be shown at the cost or the Net Realizable Value.

How to How to DISCLOSURE DISCLOSURE

Value of InventoryValue of Inventory in in Financial Financial

StatementsStatements??

Disclosure

The financial statements should disclose:

(a) the accounting policies adopted in measuring

inventories, including the cost formula used; and

(b) the total carrying amount of inventories and

its classification appropriate to the enterprise.