Methods of Inventory Pricing

The following points highlight the generally accepted methods of inventory pricing, each based on a different Assumption of cost flow.

1. Cost Price Methods:

(i) First-In, First-Out (FIFO):

The FIFO method follows the principle that materials received first are issued first. After the first lot or batch of materials purchased is exhausted, the next lot is taken up for supply. It does not suggest, however, that the same lot will be issued from stores. Sometimes, all materials are tagged with their arrival date and issued in date order especially with stocks that deteriorate. The inventory is priced at the latest costs.

Advantages:

A good system of inventory management requires that oldest units should be sold or used first and inventory should consist of the latest purchases. This is found in the FIFO method of costing.

Under the FIFO method, management has little or no control over the selection of units in order to influence recorded profits. Valuation of inventory and cost of goods manufactured are consistent and realistic. Besides, the FIFO method is easy to understand and operate.

Disadvantages:

The objectives of matching current cost with current revenues is not achieved under the FIFO method. If the prices of materials are rising rapidly, the current production cost may be understated If the sales price is fixed, then sales revenue may not produce enough income to cover the purchase of raw materials.

The valuation of inventory in terms of current cost depends on the frequency of price changes and the stock turnover. In case stocks turnover rapidly, the inventory valuations will reflect current prices. There are other limitations under the FIFO method.

FIFO costing is improper if many lots are purchased during the period at different prices. This method overstates profit especially with high inflation. It does not consider the cost of replacing used materials, a situation created by high inflation.

The FIFO method is suitable where:

(i) The size and cost of raw materials units are large,

(ii) Materials are easily identified as belonging to a particular purchased lot, and

(iii) Not more than two or three different receipts of the materials are on hand at one time.

Illustrative Problem 1:

The following is a summary of the receipts and issue of materials in a factory during January:

January:

1 Opening balance 500 units @ Rs. 25 per unit

3 Issue 70 units

4 Issue 100 units 8 Issue 80 units

13 Received from supplier 200 units @ Rs. 24.50 per unit

14 Returned to store 15 units @ Rs. 24 per unit 16 Issue 180 units

20 Received from supplier 240 units @ Rs. 24.75 per unit

24 Issue 304 units

25 Received from supplier 320 units @ Rs. 24.00 per unit

26 Issue 112 units

27 Returned to store 12 units @ Rs. 24.50 per unit

28 Received from supplier 100 units @ Rs. 25 per unit

Work out on the basis of First-in, First-out. This revealed that on the 15th there was a shortage of five units and another on the 27th of eight units.

(ii) Last-In, First-Out (LIFO):

The LIFO method of costing and inventory valuation is based on the principle that materials entering production are the most recently purchased. The method assumes that the most recent cost, generally the replacement cost is the most significant in matching cost with revenue in the income determination.

The cost of the last lot of materials received is used to price materials issued until the lot is exhausted, then the next lot pricing is used, and so on through successive lots.

Advantages:

1. It provides a better matching of current costs with current revenues.

2. It results in real income in times of rising prices, by maintaining net income at a lower level than other costing methods.

3. In industries subject to sharp materials price fluctuations, the method minimizes unrealized inventory gains and losses and tends to stabilise reported operating profits. Income is reported only when it is available for distribution as dividends or for other purposes.

4. Probably the most important arguments in favour of LIFO is its role in tax saving. It is generally considered a cheap form of tax avoidance by business firms. By valuing inventory at beginning-of-period prices and calculating cost of sales at the current prices, the firm creates secret reserves which are not taxed. As long as prices and inventory levels do not decline, this benefit remains and in this case the tax saving is permanent. However, if the tax rates go up in the meantime, the so-called tax saving will be eliminated by higher tax rates.

5. LIFO produces an income statement which shows correct profit or losses and financial position, it correlates current cost and sales, and income statements show the result of operation, excluding profits or losses due to changing price levels.

Disadvantages:

The following are the limitations of the LIFO method of costing:

1. Inventory valuations do not reflect the current prices and therefore are useless in the context of current conditions.

2. The argument that LIFO should be used for matching current costs with current revenue, is not sound. The most recent purchase costs are matched against the revenues of the current period. However, unless both purchases and sales occur regularly in even quantities, the revenues will not be matched with the current costs at the time of sale. When purchases are irregular and unrelated to the timing of sales, the matching is illogical and unsystematic, particularly if prices and costs are changing rapidly.

3. The profit of a firm can be manipulated with the LIFO method in operation. By timing purchases, a company can cause higher or lower costs to flow into the income statement, thus increasing or decreasing reported net income at will.

4. Another limitation which also results from LIFO’s lowering of the earnings figure is the effect it will have on existing bonus and profit sharing plans. Employees and managers who are interested in the growth of these plans may have difficulty in understanding a drop in the benefits which were created wholly or partially by an accounting change.

During a period of rising costs, LIFO produces the desirable effect of reducing taxable income and tax liability; thereby conserving cash. On the other hand, it also affects the profit reported in the financial statements.

Illustrative Problem 2:

Prepare a stores ledger account from the following transactions under the LIFO method:

(iii) Highest-In, First-Out (HIFO):

This method is based on the principle that materials received at the highest price in the stock are issued first. This will have the effect of pricing materials issued at the highest price and inventory valuation being made at the lowest possible prices, if the prices fluctuate widely, the highest cost will always be entering into the cost of goods sold.

For instance, suppose on a particular date the stock ledger shows stock representing 500 units at the rate of Rs. 20,700 units at the rate of Rs. 12, and 300 units at the rate of Rs. 25.

If materials are issued, then out of the above three lots, first of all 300 units would be issued. After this lot is over, then the second lot of 500 units, which becomes the highest priced stock after despatches of 300 units, would be taken up for transmission to production departments. Like other methods, this method also requires detailed records on the stores ledger.

Base Stock Price:

Under this method, it is assumed that the minimum stock of a commodity which must always be carried is in the nature of a fixed asset and is never realised while the business continues. This minimum stock is carried at original cost.

The stock in excess of this figure would be treated in accordance with one of the other methods, that is, FIFO or LIFO. The limitation of this method is that while measuring the return on capital employed in the business, the stock value may be under-valued and therefore the resulting business results will not be reliable.

Illustrative Problem 3:

From the following information prepare a stores ledger account assuming 100 units as base stock following the FIFO method:

2. Average Price Methods:

(i) Simple Average:

This method is based on the principle that materials issued should be priced on an average price and not on exact cost price. The simple average is an average of prices without having regard to the quantities involved.

It should be used when prices do not fluctuate very much and the stock value is small. The average under this method is calculated by dividing the total of rates of materials in the storeroom by the number of rates of prices. This method is easy to operate.

Illustrative Problem 4:

Prepare a stores ledger account by following the simple average method on the basis of information given in Illustrative Problem 3:

(ii) Weighted Average:

Under this method, issue of materials is priced at the average cost price of the materials in hand, a new average being computed whenever materials are received. In this method, total quantities and total costs are considered while computing the average price and not the total of rates divided by total number of rates as in simple average. The weighted average is calculated each time a purchase is made.

The quantity bought is added to the stock in hand, and the revised balance is then divided into the new cash value of the stock. The effect of early price is thus eliminated. This method avoids fluctuations in price and reduces the number of calculations to be made, as each issue is charged at the same price until a fresh purchase necessitates the computation of a new average. It gives an acceptable figure for stock values.

Advantages:

The following are the advantages of the weighted average method:

1. The method is logical and consistent as it absorbs cost while determining the average for pricing material issues.

2. The changes in the prices of materials do not much affect the materials issues and stock.

3. The method follows the concept of total stock and total valuation.

4. Both cost of materials issued and in stock tend to reflect actual costs.

Disadvantages:

However, the weighted average method also has the following disadvantages:

1. Simplicity and convenience are lost when there is too much change in the pries of materials.

2. An average price is not based on actual price incurred, and therefore is not realistic. It follows only arithmetical convenience.

Illustrative Problem 5:

Prepare a store ledger account on the basis of information given in Illustrative Problem 3 by following the weighted average method:

(iii) Periodic Simple Average:

In cost accounting, where job costs may be prepared infrequently, say monthly, or bimonthly, it may be necessary to price materials issued by taking the average price ruling during that period. If it is calculated monthly, the average of the unit prices of all the receipts during the month is adopted as the rate for pricing issue during the month. Only a simple calculation has to be done at the end of the accounting period.

The opening stock is not considered for computing periodic simple average because it has not been purchased during the current period and would have been included in the previous year’s calculations.

However, purchases made during the current year and closing stock are taken into account while computing this average. Basically, this method follows the principle of simple average price, but a period is set for which the average is calculated.

Taking the above example, the total receipts and issue of the materials would be shown as follows:

(iv) Periodic Weighted Average:

This method is quite similar to the weighted average price method with only one difference that in this method average price is not calculated at the time of every new receipt of materials but only periodically.

Periodic weighted average is calculated by dividing the total value of the materials purchased during a given period, by the total quantity purchased during the same period. Opening stock—its value and quantity both—are not considered while computing this average.

In the above example, the periodic weighed average will be computed as follows:

(v) Moving Simple Average:

Under this method, periodic simple average prices are further averaged. In this way, moving average is obtained by dividing periodic average prices of different periods by the number of periods taken. The periods chosen cover the period in which the material is issued. The following example explains this method.

In the above example, moving average has been obtained for a six month period.

The moving simple average method will give prices to be used for materials issued which are below the periodic average prices. This will be true when prices are showing an upward trend. In periods of falling prices, the resulting issue prices under the moving average method will be greater than the periodic average prices. This influences the value of closing stock which may be under-valued or over-valued.

(vi) Moving Weighted Average:

This method finds the materials issues price by dividing the total of the periodic weighted average prices for a number of periods by the total number of such periods. This is similar to the moving simple average method.

3. Normal Price Methods:

(i) Standard Price:

This method charges materials issued into the factor at a predetermined budgeted, or estimated price reflecting a normal or an expected future price. A standard price is fixed for each class of materials in advance after making proper investigations. Receipts and issues of materials are recorded in quantities only on the materials ledgers, thereby simplifying the record keeping.

The difference between actual price and standard price is transferred to a purchase price variance which reveals to what extent actual costs are different from standard materials cost. Materials are charged into cost of goods sold at the standard price avoiding inconsistencies in different actual cost methods.

This method helps in knowing the purchase efficiency. If the total actual cost is less than the standard price, there will be favourable purchasing efficiency and vice versa. This methods is simple to operate and provides stability in costing system.

However standard price does not often reflect actual or expected cost, but only a generalized target. The stock value need not show actual cost incurrence and therefore does not necessarily conform to acceptable principles of stock valuation.

(ii) Inflated Price:

This price includes carrying costs, cost of contingencies and also the losses arising out of evaporation, shrinkage, etc. This method aims to cover/recover the full cost of materials purchased.

(iii) Replacement Price or Market Price:

Under this method, materials issues are priced at replacement price on the date the issue is made. The replacement cost (market price) is the cost of securing the same type of material at the current moment in time.

This method has the following advantages:

Advantages:

1. The replacement cost approach matches current revenue against current cost and is therefore useful in measuring the operating results of a business firm correctly and accurately.

2. The use of replacement cost brigs out clearly the difference between holding gains and operating gains and financial statement users will have a better understanding of the financial statement. If replacement cost is not used, the profit resulting due to holding of materials and inventory is taxed and therefore, impairs the capital of a business firm.

3. The replacement price if used, will disclose good or bad buying made by the purchase department of the firm.

4. The replacement cost approach helps in determining a selling price for the product which is competitive and realistic.

5. In case the prices of materials have decreased, the materials should be charged to the production at the current replacement price and the resulting loss should be taken into consideration in the accounts of the firm.

Disadvantages:

However, this method has certain disadvantages. Firstly, the objectivity is lost in accepting the replacement cost as the basis of materials pricing. The “replacement” concept is a relative one and in the absence of market for the materials, no equitable replacement price is determinable. This increases the subjectivity in selection of a current replacement price.

Secondly, this is not based on actual cost, that is, cost incurred, and therefor may add confusion and complications in cost accounting. Thirdly, this method is workable only when market prices are available and reflect current cost of replacing the materials.

Illustrative Problem 6:

The following are the transactions in respect of purchase and issue of components forming part of an assembly of a product manufactured by a firm which requires to update its cost of production, every often for bidding tenders and finalising cost plus contracts:

The stock on January 1, 2007 was 5,000 Nos. valued at Rs. 1.10 each. State the method you would adopt in pricing the issue of components giving reasons. What value would be placed on stocks as on March 31 which happens to be the financial year-end and how would you treat the difference in value if any, on the stock account?

The stores ledger shows that the value of closing stock based on actual cost is Rs. 3,010. The last purchase effected on March 17@ Rs. 1.30 per unit represents the current market price. On this basis, the value of stock as on March 31 works out to Rs. 3,380. This is higher than cost. Moreover in cost books stocks are shown at cost and not at market value. Hence, no adjustment is otherwise necessary.

Illustrative Problem 7:

From the records of an oil distributing company, the following summarised information is available for the month of March 2005:

Sales of the month: Rs. 19,25,000

Opening Stock as on 1.3.2005: 1.25,000 litres @ Rs. 6.50 per litre

Purchases (including freight and insurance):

March 5 – 1,50,000 litres @ Rs. 7.10 per litre

March 27 – 1,00,000 litres @ Rs. 7.00 per litre

Closing stock as on 31.3.2005: 1,30,000 litres.

General administrative expenses for the month: Rs. 45,000

On the basis of the above information, work out the following using FIFO and LIFO methods of inventory valuation assuming that pricing of issues is being done at the end of the month after all receipts during the month:

(а) Value of closing stock as on 31.3.2005

(b) Cost of goods sold during March 2005

(c) Profit or loss for March 2005

Illustrative Problem 8:

Show how the items given ahead relating to purchases and issue of raw material item will appear in the stores ledger card, using weighted average method for issue pricing:

Illustrative Problem 9:

The Stock Ledger Account for Material X in a manufacturing concern reveals the following data for the quarter ended Sept. 30, 2008:

Physical verification on Sept, 30, 2008 revealed an actual stock of 3,800 units. You are required to:

(а) Indicate the method of pricing employed above.

(b) Complete the above account by making entries you would consider necessary including adjustments, if any, and giving explanations for such adjustments.

Solution:

(а) The verification of the value of issues applied in the problem shows that Weighted Average Method of pricing has been followed.

For example, the issue price of 1200 units of July 13 will be Rs. 2.13 (Rs. 2566/1200 units) which is the weighted average price of purchase made on July 9 and July 1 opening stock, calculated as follows:

(b) The complete Stores Ledger account giving the transactions as stated in the problem together with the necessary adjustments is given below:

Closing Stock: 3,800 units, value of closing stock = Rs. 8,995

Shortage of 200 units has been charged at the weighted average price of the goods in stock.

Closing stock 3800 units x Rs. 2.37 = Rs. 9006. Since the figures of issue prices have been taken directly as given in the question, there is a minor difference in the value of closing stock.

Illustrative Problem 10:

The following transactions in respect of material Y occurred during the six months ended 30th June, 2005:

Required:

The chief accountant argues that the value of closing stock remains the same, no matter which method of pricing of material issues is used. Do you agree? Why or why not? Detailed stores ledgers are not required

Solution:

In the given problem the total number of units purchased from January to May 2005 is 1,900 and the same have also been issued during this period. Thus, there was no stock at the end of May, 2005 which could become opening stock for the next month.

In June, 2005; only a single purchase and a single issue of material was made. The closing stock is of 200 units. In this situation, stock of 200 units at the end of June, 2005 will be valued at Rs. 20 per unit irrespective of the pricing method of material issues. Hence, one would agree with the argument of the Chief Accountant.

However, this will not be true with the value of closing stock at the end of each month. Moreover, the value of closing stock at the end of June, 2005 would have been different under different pricing methods if there were several purchases at different prices and several issues during the month.

Illustrative Problem 11:

ABC Limited provides you the following information. Calculate the cost of goods sold and ending inventory, applying the LIFO method of pricing raw materials under the Perpetual and Periodical Inventory Control System:

Reasons for Difference in Profits:

The cost of goods sold/issued/withdrawn is more under Periodic Inventory System as compared to Perpetual Inventory System. Hence, the profit under the former will be less as compared to the later. Alternatively, it can be so said that less the amount of ending inventory, less will be the profits.

Illustrative Problem 12:

The following are the particulars regarding receipts and issues of certain material:

The credit balance of price variance account, before transfer to costing profit and loss account, was Rs. 500. Calculate the standard rate at which the above issues should be made, and determine the value of closing stock.

Solution:

The standard price at which the materials were issued in the last period was Rs. 9. This gave a profit of Rs. 500.

Therefore, this time, materials should be valued at a lower standard price as compared to last period.

The standard price for this period should therefore be:

The value of stock at standard price is Rs. 29750 (3500 x 8.50). The stock therefore will be valued at Rs. 29.750 and Rs. 750 will be debited to the price variance account.

4. Specific Identification Method:

The specific identification method involves:

(a) Keeping track of the purchase price of each specific unit.

(b) Knowing which specific units are sold and

(c) Pricing the ending inventory at the actual prices of the specific units not sold.

The objective is to match the unit cost of the specific item sold with sales revenue. This method is based on the assumption that each unit purchased, sold or in inventory has its own identity, that it is separate and distinguishable from any other unit. Each unit sold or remaining in inventory is identified and its specific unit cost is used in calculating cost of goods sold or ending inventory cost.

To take an example, assume that an art dealer purchased two seemingly identical pieces of pottery during a period. The first piece is purchased for Rs. 3000 and the second is purchased several months latter for Rs. 3,500. Assume also that only one of these items is sold by the dealer during the period.

The amounts assigned to cost of goods sold and ending inventory will depend on which specific piece of pottery is sold. If the item sold is the first piece of pottery, cost of goods sold is Rs. 3000 and ending inventory is Rs. 3,500. On the other hand, if the second piece is the one sold, the numbers would be reversed; that is cost of goods sold will be Rs. 3,500 and ending inventory would be Rs. 3000.

The specific identification method provides a highly objective procedure for matching costs with sales revenue because the costs flow pattern matches the physical flow of the goods. However, this method does not work for large volumes of identical low-cost items.

This method is appropriate for companies that handle a relatively low volume of physical units, each having a high cost per unit such as original oil paintings, antiques, diamonds, automobiles, jewellery, furs etc. The specific identification method is not appropriate where each unit is the same in appearance but is differentiated from other units through serial numbers, such as the same model of washers, refrigerators or televisions.