INVENTORY LEARNING OUTCOMES
8. INVENTORY LEARNING OUTCOMES
At the end of the topic, the student should be able to:
Understand the Cost Formula The important of Correct Inventory valuation
8.1. INTRODUCTION
Inventory is one of the more important assets for many entities. Inventory can
be classified as all or any one of the following:
Goods which are kept to be sold in the normal course of business (merchandise)
Goods which are in the process of being manufactured for sale Goods which are used during the manufacture of inventory for sale (e.g.
manufacturing material) Goods which are consumed in the normal business activities (e.g. stationery)
It is important to keep strict control over inventory and this is often done by means of an inventory count, which usually takes place at the end of the financial year. Even if an inventory count occurs on a continuous basis throughout the year it is still customary to count the inventory annually.
8.2 COST FORMULAE
It is very important to have an understanding of the weighted average, first-in- first-out, specific identification, standard cost, and retail methods in the allocation of cost.
The cost of inventory comprises the total of:
The cost of purchases Processing costs Other costs incurred in bringing the inventory to its present location and condition
These costs are all included in the cost of the inventory in order that, when the inventory is sold, they as the cost of sales can be matched with sales included as income in the income statement. If these costs were not included in the cost of inventory, they would immediately have to be written off as expenditure in the income statement. When an enterprise purchases various batches of an inventory item at different prices, and only a portion of the purchased goods are on hand at the end of a financial period, the question arises as to which of the prices paid for the batches should be considered to be the purchase price of the batches still on hand. The method used to allocate costs to inventory, and therefore used in determining the cost of goods, should be the one which brings about the most realistic determination of profit in the particular enterprise. At present, several principles are applied to allocating cost, with varying results. They include the following:
Weighted average method: The total cost of the goods available for sale is divided by the total number of units in order to determine an average cost per
unit. First in first out (FIFO) method: According to this method it is accepted that the items which were purchased first are sold first. Inventory on hand is
therefore valued at the latest prices. Specific identification method: The actual cost of a particular item is allocated to that item. Standard cost method: In accordance with this method the determination of cost occurs in terms of predetermined standards
Examples of the various methods are discussed below: The weighted average method
This method is applicable where a large number of homogenous inventory items are stocked.
Purchases
Cost
Per Batch
Unit cost Per batch
Weighted average cost
per batch
Total Units
Total
R1.00 (R100/100) 300
R1,075(R430/400) 200
R1060 R1,178(R1060/900) 100
R1200 R1.20(R1200/1000)
The first in first out method (FIFO)
This method is especially applicable where a large quantity of homogenous items are stocked, because in such a case it does not make a difference whether the older or newer items are included in a sales transaction. It is based on the point of departure that the older inventory is usually sold first. In accordance with this method the cost of goods on hand and the cost of goods sold would be calculated as follows, using the same data as in the previous example.
Cost of goods on Date
Cost of
Purchases Unit Price Sales
On hand
goods sold hand
The specific identification method of valuation is often used by enterprises, because it tends to value inventory at current prices. However in the income statement, prices are matched with sales, which represents selling prices. For this reason it is sometimes said that this method leads to an incorrect application of the matching concept.
The FIFO and Weighted average method will have different results as illustrated by the following:
FIFO Sales (e.g. 600@ R4, 00)
Average Cost
2400 Cost of goods sold
670 Gross profit
The specific identification method
Specific identification is the basis on which specific costs are allocated to identify inventory items.
It is a suitable method for goods that are purchased or manufactured for a specific project, for example inventory items that cannot normally be It is a suitable method for goods that are purchased or manufactured for a specific project, for example inventory items that cannot normally be
In this case it is necessary to determine precisely on which date each of the 400 units which are still in stock on 31 March, were bought.
The total cost of the goods were R1200
Suppose that the 400 units on hand comprise the following:
20 units purchased on 1 March
80 units purchased on 8 March 100 units purchased on 15 March 100 units purchased on 22 March 100 units purchased on 29 March
The cost of the inventory on hand on 31 March is therefore:
20 units @ 1,00 = 20
80 units @ 1,10 = 88 100 units @ 1,20 = 120 100 units @ 1,30 = 130 100 units @ 1,40 = 140
Cost of goods on hand: R498
The cost of goods sold is therefore: Total cost = 1 200 Cost of inventory on hand = 498
R702
8.3. THE IMPORTANCE OF CORRECT INVENTORY VALUATION
It is very important that inventory is valued correctly. A mistake in the inventory figure will affect the calculation of cost of sales, the gross profit and subsequently profit in the statement of comprehensive income. On the statement of financial position the total of the current assets as well as the equity will be incorrect. This mistake will also affect the figures for the following year, because the closing inventory for one year is the opening inventory for the next year.
TOPIC 9 ________________________________________________________________