Inventories will be calculated at the least of cost or market value. However, how do we determine the cost of a particular item or stock? We generally rely on various methods of historical cost valuation. Let us take a look at the four most used historical cost methods like LIFO and FIFO.
1] Special Identification Method
Here we must keep track of each item of the inventory. So we must identify and record the cost of every item of the stock. And the total value of closing inventory is got by adding up the costs of all the items.
This can be a tedious process but is required if the goods are job-specific. So if the goods are assigned to a specific job or process, then the special identification method will be necessary for inventory valuation. Another advantage of this method is that it actually adheres to the flow of the goods. It also matches the costs to the revenue.
2] First in First Out Method (FIFO)
In this method, materials are issued in the order of which they are received by the company. This means the goods that came in first will also be issued first. Hence the name first in first out (FIFO). So the older stocks are considered to be issued first, before the new stock items. So the stock lying with the company at year end will be the one with the latest market price.
One of the biggest advantages of this method is that it is easy to maintain and record. And the closing stock of the firm will be a reflection of the current market value. It also has the added advantage of being logical, since it follows a more likely flow of goods. But when the price of the goods fluctuate a lot the calculation by the FIFO method can get more difficult and complicated.
3] Last in First Out (LIFO)
This method is the stark opposite of FIFO. Here the goods that are received last are issued first. So the issue of goods is made from the latest purchase, and the previous purchases lie in stock. So unlike FIFO, LIFO does not follow a chronological order while issuing the goods.
While LIFO is a better method for matching the costs to the revenue it is otherwise an illogical method. Most companies want to use this method to manipulate their stock valuation when the prices are rising. Another major disadvantage is that the stock at the year-end will not reflect the market value of stocks. This is the reason why most tax authorities do not find LIFO and acceptable method of recording inventory.
4] Average Method
There are two types of average methods – simple and weighted. In the simple average method, all the different prices of the purchases are added together and divided by the number of prices. This will give us one average price. We then value our closing stock at this price. When a firm does not have to identify specific costs to the revenue this method can be used.
In the weighted average method, the quantity and price of goods both are taken into account to arrive at the average price. So if we buy 100 goods at Rs 5/- and 200 goods at Rs 6/-, the weighted average rice will be (100×5) + (200×6) / 300 = 5.667/-
Solved Example for You
Q: Following are the details of purchases of XYZ & Co. Find the closing stock using the FIFO method.
|March 1||Opening Stock||60 units @ 100|
|March 5||Purchase||140 units @ 110|
|March 16||Sale||180 units @ 120|
|March 23||Purchase||60 units @ 115|
Ans: Units Available for Sale = 60+140+60 = 260
Units Sold = 180
Closing Inventory = 80 units
Cost of Closing Inventry = (20 units @ 110) + (60 units @ 115) = 9100