Inventory: Examples

Inventory is tangible current asset.

It includes finished goods, work in progress, and raw materials.
Inventories include assets held for sale in the ordinary course of business (finished
goods), assets in the production process for sale in the ordinary course of business
(work in process), and materials and supplies that are consumed in production (raw
materials). [IAS 2.6]

Inventory Valuation
Valuation of inventory is crucial because of its direct impact in measuring profit/loss and
also on financial position.

Inventory Cost
Cost of inventories should include only those cost which are expected to generate future
expected benefits. Such cost includes the cost of acquisition and cost that change either
i. Location of the inventory e.g. freight, carriage, import duty or
ii. Condition of the inventory, e.g. costs incurred to convert the raw materials into finished
goods.
 Cost should include all: [IAS 2.10].
 Costs of purchase (including taxes, transport, and handling) net of trade
discounts received.
 Costs of conversion (including fixed and variable manufacturing overheads) and
 Other costs incurred in bringing the inventories to their present location and
condition.

Inventory Valuation
Inventories should be valued at cost or net realisable value whichever is lower. (AS-2/
IAS 2.9) This is based on view that no asset should be carried at a value which is in
excess of the value realisable by its sale or use.
Net realisable value is the estimated selling price in the ordinary course of business less
the estimated cost of completion and estimated cost necessary to make sale.

Example
Cost of semi-finished products at the end of the 2011-12 is R70 000. This product can
be finished in the next year by further expenditure of R10 000. This product can be sold
at R60 000 subject to selling commission of 5% on selling price. Determine the value of
inventory for the year ended 2011-12.

Solution:
Selling Price 60 000
Less: Estimated cost of completion 10 000
Less: Commission 3 000
Net realisable value 47000
NRV : Rs. 47000
Cost : Rs. 70000
Therefore, value of inventory (lower of cost and NRV): 47000
Overview: What is inventory accounting?
Inventory accounting is the valuation of inventory products for resale.

The management of both inventory purchases and inventory turnover should follow

Generally Accepted Accounting Principles (GAAP) rules, which require that all
inventory be properly accounted for using either the cost method or market value
method.

It’s also important to remember that inventory is considered a current asset, so it is

not depreciable.

If you only sold a single item, inventory accounting would be simple, but it’s likely
that you have multiple items in inventory and need to account for each of those items
separately. While this is not difficult, you can quickly run into complications when
inventory costs vary.

Both cost of goods sold and inventory valuation depend on accounting for inventory

properly. And because inventory is considered an operating expense, materials and
product purchases directly impact your income statement, while an increase in
inventory levels will directly affect your balance sheet totals as well.

Inventory accounting is used primarily to determine cost of goods sold, and to value
inventory at the end of each accounting period. When determining your cost of
goods sold for a specific accounting period, the formula is:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

For instance, your beginning inventory for the month of March is valued at $5,250.
You purchase additional inventory in the amount of $4,100 and end the period with
an inventory value of $3,100. Here’s how you would calculate your cost of goods
sold for the month of March:

$5,250 + $4,100 – $3,100 = $6,250

Inventory valuation is determined by attaching a specific value to the products that

remain in inventory at the end of the accounting period.

We’ll show you how to do that using the three most frequently used inventory
accounting methods: first in/first out (FIFO), last in/first out (LIFO), and weighted
average, with each method having advantages and disadvantages.
How to do inventory accounting with the FIFO method
First in/first out, or FIFO, is the most common type of inventory valuation method
used. It's fairly self-explanatory: First in/first out simply means that the inventory
items that were purchased first, or the oldest, are the first to be sold.

For example, on January 2, 2020, you purchase 100 crystals from your regular
supplier at a cost of $4 each. On January 15, you need to purchase an additional
100 crystals, but your regular supplier raised the price to $6 each.

When your supply begins to run low in late January, you turn to another supplier,
who offers you a price of $5 per crystal, so on January 30, you purchase an
additional 100 crystals at the new cost.

In order to properly track your inventory costs and the value of your remaining
inventory at month's end, you will need to track pricing and sales for all three pricing
levels since how you account for your inventory pricing will directly affect your cost of
goods sold, and your inventory valuation.

Let’s break this down further:

 1-02-2020: 100 crystals @ $4 each = $400

 1-15-2020: 100 crystals @ $6 each = $600
 1-30-2020: 100 crystals @ $5 each = $500

In addition to purchasing the crystals in January, you also had two large customer
orders; one on January 20 for 125 crystals and one on January 31 for 140 crystals.
Here is how you would value the inventory that was purchased on 1-20-2020 using
the FIFO method:

 100 crystals @ $4 each = $400

 25 crystals @ $6 each = $150
 Total cost of inventory = $550

Because we’re using the FIFO method, our order includes the first crystals that were
placed in stock, which were $4 each. The remaining crystals in the order were taken
from the second group of crystals purchased, which were $6 each.

The next purchase, completed on 1-31-2020 would be:

 75 crystals @ $6 each = $450

 65 crystals @ $5 each = $325
 Total cost of inventory = $775

With this order, the oldest crystals in stock, which were $6 each, were sold first,
along with 65 crystals from the most recent purchase. After both of these purchases
were completed, you were left with 35 crystals in stock, all valued at $5 each for a
total value of $175.
Here is a chart that breaks down the inventory activity using the FIFO valuation
method:

DATE TRANSACTION UNITS COST PER UNIT TOTAL COST

1-01-2020 Opening Inventory 0
1-02-2020 Purchased crystals 100 $4 $400
1-15-2020 Purchased crystals 100 $6 $600
1-20-2020 Customer order (FIFO) -100 $4 -$400
1-20-2020 Customer order (FIFO) -25 $6 -$150
1-30-2020 Purchased crystals 100 $5 $500
1-31-2020 Customer order (FIFO) -75 $6 -$450
1-31-2020 Customer order (FIFO) -65 $5 -$325
1-31-2020 Ending inventory valuation 35 $5 $175

Table that breaks down the inventory activity using the FIFO valuation method

The cost of goods sold for the month of January using the FIFO accounting method
is:

$0 + $1,500 - $175 = $1,325

How to do inventory accounting with the LIFO method

Last in/first out, or LIFO, calculates inventory value based on the premise that the
last inventory items purchased are the first ones sold. Using the same transactions
as above, here is how your inventory totals would differ using LIFO:

The first customer purchase, made on January 20 would be:

 100 crystals @ $6 each = $600

 25 crystals @ $4 each = $100
 Total cost of inventory = $700

Using LIFO, because the $6 crystals were the last inventory items added before the
customer’s purchase on January 20, they are the first ones sold.

The next purchase, completed on January 31, would be:

 100 crystals @ $5 each = $500

 40 crystals @ $4 each = $160
 Total cost of inventory = $660

After these purchases, you were left with 35 crystals in stock, all valued at $4 each
for a total value of $140, since using the LIFO method, both the $5 crystals and the
$6 crystals were sold first, leaving only the $4 crystals in stock.
 DATE TRANSACTION UNITS COST PER UNIT TOTAL COST
1-01-2020 Opening Inventory 0
1-02-2020 Purchased crystals 100 $4 $400
1-15-2020 Purchased crystals 100 $6 $600
1-20-2020 Customer order (FIFO) -100 $6 -$600
1-20-2020 Customer order (FIFO) -25 $4 -$100
1-30-2020 Purchased crystals 100 $5 $500
1-31-2020 Customer order (FIFO) -100 $5 -$500
1-31-2020 Customer order (FIFO) -40 $4 -$160
1-31-2020 Ending inventory valuation 35 $4 $140

Table that breaks down the inventory activity using the LIFO valuation method

The cost of goods sold using the LIFO method for the month of January is $1,360.
The calculation is:

$0 + $1,500 - $140 = $1,360

LIFO is often used for tax purposes, based on the assumption that the most recent
inventory is the most expensive. Using LIFO can reduce taxable income levels,
resulting in a smaller tax bill.

How to value inventory using the weighted average

method
The weighted average method averages the total cost of your inventory. In this case,
you would add the cost of all three of your inventory purchases for the month:

 100 crystals @ $4 each = $400

 100 crystals @ $6 each = $600
 100 crystals @ $5 each = $500

Next you would add your total inventory count for the month, which would be 300. To
find the weighted average for your inventory, you would use the following formula:

$1,500 ÷ 300 = $5

DATE TRANSACTION UNITS COST PER UNIT TOTAL COST

1-01-2020 Opening Inventory 0
1-02-2020 Purchased crystals 100 $4 $400
1-15-2020 Purchased crystals 100 $6 $600
1-20-2020 Purchased crystals 100 $5 $500
1-30-2020 Customer order (weighted average) -125 $5 -$625
1-31-2020 Customer order (weighted average) -140 $5 -$700
1-31-2020 Ending inventory valuation 35 $5 $175
 Table that breaks down the inventory activity using the weighted average valuation
method

Using the weighted average, the ending inventory valuation would be $175, while the
cost of goods sold for the month would be:

$0 + $1,500 - $ $175 = $1,325

Weighted average is best used in a manufacturing environment where inventory is

frequently intermingled, and difficult to track separately.

Inventory accounting doesn’t have to be difficult

Whether you’re manufacturing items or purchasing products from a supplier for
resale, it’s essential that inventory be accounted for properly. Finding the method
that best suits your business can go a long way toward making the process easier.

Using good accounting software can also simplify inventory management by

assisting with the inventory valuation process; tracking inventory movement,
including sales orders and customer purchases; and producing financial statements
such as a balance sheet or profit and loss statement.

If you’re looking for accounting software that can track inventory for your business,
be sure to check out The Blueprint’s accounting software reviews.