Historic Cost Methods for valuing inventory

One way of valuing Inventory is to assign all the costs already incurred to bring it to its present status. According to IAS-2, these costs shall include all the costs directly attributable to the inventory. These costs include the cost of purchase, conversion, Taxes and duties, any cartage paid or any other directly attributable expenses.

The use of historic cost to value inventory also satisfies the matching concept/ principle of Accounting, which requires that the revenue earned shall be matched to the expenses incurred to earn that revenue. It seems logical that while calculating the profit, all the cost incurred to purchase the goods and make finished goods shall be deducted from the revenues earned by sales of these goods/ Inventory.

Further, valuing Inventory at its historic value is an objective method of valuation as costs already incurred can easily be verified and audited from the accounting records. This objectivity of the historical cost method of valuing inventory makes it acceptable across all the users of Financial Statements.

However, as the Historic cost of valuing inventory is based on the costs already incurred, therefore in times of inflation it does not consider the impact of financial gains due to cheaper purchases made earlier until the product/ inventory is sold. For example if the business bought a product at $ 10 per unit and now after a month the cost of the same item is $ 12, it means that the business has saved $2 because it was purchased earlier. This saving (gain) of $2 cannot be realized until it is sold as Inventory will be valued at $10 in books of accounts if the historic cost method of valuing inventories were followed.

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First In First Out (FIFO)

As appears from the name this method of Inventory valuation is based on the assumption that the items are issued/ sold out in the order in which they were bought in. The inventory purchased earlier will also be issued before the new stock. Therefore in this method, rates are assigned to stock being issued or consumed, based on the oldest stock available.

For Example a stationary seller made following purchases during the Month of August-2X20:

01 August 2X20Purchase 05 Notebooks @ $2 each                      $10$10
05 August 2X20Sold 02 Notebooks                                   ($4)$6
06 August 2X20Purchase 10 Notebooks @ $3 each                      $30$36
08 August 2X20Sold 08 Notebooks (Balance 05 Notebooks)
03 Notebooks @$2 each, remaining from stock purchased on 05 August
05 Notebooks @$3 each, from fresh stock purchased on 06 August 

From the above illustration, it can be seen how value is assigned to the issuing stock while using the FIFO method of Inventory Valuation.

For each issuance/consumption, first rate from the inventory items from the oldest available lot are assigned and if the items from the oldest lot have been finished, only then the rate of items from the new lot are assigned to remaining items being issued.

Consider the item sold on 08th August 2X20. At this date we had a total of 13 notebooks, 03 notebooks from the oldest lot (purchased at 01st August), whereas 10 from the fresh lot (purchased at 06th August).Total 08 Notebooks were sold.

While assigning the value to notebooks being sold, it was assumed that first notebooks from the oldest stock will be sold, so we assigned the rate of $2 to 3 notebooks and $3 to 5 other notebooks, thus totaling to $21 (3 @ $2=$6 plus 5 @$3=$15).

Further, all the remaining 5 notebooks are from the lot purchased at 6th August, therefore stock at the 8th August being valued at $3 each and totaling to $15 (5 remaining Notebooks @ $ 3 each).

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Advantage of using fifo

Adopting FIFO method of valuing inventory have the following advantages:

·         The FIFO method of valuation follows the common practice of issuing the oldest stock first. Practically, businesses issue/ consume the oldest stock first so the inventory may not get obsoleted or to avoid wear and tear of the items. Further the inventory items with a limited shelf life shall also be sold/ issued first.

·         In the FIFO method historic costs are assigned for valuing Inventory, therefore unrealistic profits cannot be recorded.

·         In the FIFO method of valuation, the majority of closing stock consists of the item most recently purchased, therefore, it can be argued that the closing stock reflects the nearest possible market value.

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Disadvantages of using FIFO

   In FIFO method of valuing stock, rates from the oldest available lot are assigned to the item being issued/ sold, hence one can say that Cost of Goods Sold does not reflect the current market prices.

·         In production setups where production is done in lots or based on Job orders, it becomes difficult to compare the cost of two similar jobs. This is because the job/ lot first produced will have the rates of purchases made earlier, and the 2nd Job will have the costs of material purchased later despite the actual order of issuance of raw material for each job.

For example Job A required a high quality of a specific raw material, which company has to purchase fresh only for Job A, whereas Job B required an inferior quality of the same material which was already available with the company. If Job A started 1st, then in reality expensive material is being consumed for the production of Job A. However, due to the adoption of FIFO method, the rates of already held material (i.e. cheaper material) being charged for material issuance to Job A. On the other hand, as Job B started after Job A, the cost assigned to the material being issued for Job B will be of the purchases made latter (i.e. expensive material).

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Suitability for using FIFO method

The FIFO method of valuing inventory is suitable for the items with a limited shelf life, as this method of valuing inventory will reflect the original sequence of item issuance for such being followed.

This method of valuation is also suitable where materials are purchased in large quantities and with less frequency.

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