Stock Valuation

First in first out (FIFO) method

The first in first out (FIFO) method of costing is used to introduce the subject of materials costing.
The FIFO method of costing issued materials follows the principle that materials used should carry
the actual experienced cost of the specific units used. The method assumes that materials are issued
from the oldest supply in stock and that the cost of those units when placed in stock is the cost of
those same units when issued. However, FIFO costing may be used even though physical withdrawal
is in a different order.

Advantages of First in First out (FIFO) Costing Method:

1. Materials used are drawn from the cost record in a logical and systematic manner.
2. Movement of materials in a continuous, orderly, single file manner represents a condition
necessary to and consistent with efficient materials control, particularly for materials subject
to deterioration, decay and quality are style changes.

FIFO method is recommended whenever:

1. The size and cost of units are large.

2. Materials are easily identified as belonging to a particular purchased lot.
3. Not more than two or three different receipts of the materials are on a materials card at one
time.

Last in first out (LIFO) method

The last in first out (LIFO) method of costing materials issued is based on the premise that materials
units issued should carry the cost of the most recent purchase, although the physical flow may actually
be different. The method assumes that the most recent cost (the approximate cost to replace the
consumed units) is most significant in matching cost with revenue in the income determination
procedure.

Under LIFO procedures, the objective is to charge the cost of current purchases to work in process
or other operating expenses and to leave the oldest costs in the inventory. Several alternatives can be
used to apply the LIFO method. Each procedure results in different costs for materials issued and the
ending inventory, and consequently in a different profit. It is mandatory, therefore, to follow the
chosen procedure consistently.

Advantages of Last In First Out (LIFO) Method:

The advantages of the last in first out method are:

Materials consumed are priced in a systematic and realistic manner. It is argued that current
acquisition costs are incurred for the purpose of meeting current production and sales requirements;
therefore, the most recent costs should be charged against current production and sales. Unrealized
inventory gains and losses are minimized, and reported operating profits are stabilized in industries
subject to sharp materials price fluctuations.
Inflationary prices of recent purchases are charged to operations in periods of rising prices, thus
reducing profits, resulting in a tax saving, and therewith providing a cash advantage through deferral
of income tax payments. The tax deferral creates additional working capital as long as the economy
continues to experience an annual inflation rate increase.

Disadvantages of the LIFO Costing Method:

The disadvantages or limitations of the last in first out costing method are:

1. LIFO is not deemed an acceptable stock valuation based on International Accounting

Standards
2. Record keeping requirements under this method, as well as FIFO, are substantially greater
than those under alternative costing and pricing methods.
3. Inventories may be depleted due to unavailability of materials to the point of consuming
inventories valued at older or perhaps the oldest prices. This situation will create a miss
matching of current revenue and cost, sometimes companies using this costing method
counteract this problem by establishing an allowance for replacement of the LIFO inventory
account. Cost of goods sold is charged with current cost. The allowance account is credited
for the access of the current replacement cost over the LIFO carrying cost for the inventory
temporarily liquidated. When this inventory is replenished, the temporary allowance (credit)
is removed and the goods acquired are placed in inventory at their old last in first out cost.

Average Cost
Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of
uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or
label each materials item with an invoice price in order to identify the used units with its acquisition
cost. It may be reasoned that units are issued more or less at random as for as the specific units and
the specific costs are concerned and that an average cost of all units in stock at the time of issue is
satisfactory measure of materials cost. However, average costing may be used even though the
physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items
low in unit cost and especially if prices are subject to frequent changes.

Advantages of Average Costing Method:

Average costing method has the following main advantages:

1. It is a realistic costing method useful to management in analyzing operating results and

appraising future production.
2. It minimizes the effect of unusually high or low materials prices, thereby making possible
more stable cost estimates for future work.
3. It is practical and less expensive perpetual inventory system.

The average costing method divides the total cost of all materials of a particular class by the number
of units on hand to find the average price. The cost of new invoices is added to the total in the balance
column; the units are added to the existing quantity; and the new total cost is divided by the new
quantity to arrive at the new average cost. Materials are issued at the established average cost until a
new purchase is recorded. Although a new average cost may be computed when materials are returned
to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems
sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain
unchanged. When a new purchase is made and a new average is computed, the discrepancy created by
the returns will be absorbed.i

Using the information provided by John Doe, we can compute the value of closing inventory, based
on the three inventory valuation methods discussed:

Date Purchases Date Sales

1-Aug 120 units @ $120 6-Aug 100 units @ $140
8-Aug 50 units @ $125 10-Aug 55 units @ $145
16-Aug 20 units @ $140 25-Aug 40 units @ $160
20-Aug 30 units @ $150

*Note: Only the quantity under the sales column is relevant for inventory valuation. The Sales
prices of $140, $145 and $160 are relevant for determining Total Sales.
Using all three methods we observe that the quantity of closing inventory remains the same.
However, the value will differ based on the method being used. We can compare all three
methods using a Trading Account as illustrated on the next page:
 The use of the LIFO stock valuation method provides the lowest Gross Profit figure which is
advantageous during periods of inflation, however, recall that this method is not acceptable per
IAS!

Stock turnover ratio

This ratio is a relationship between the cost of goods sold during a particular period of time
and the cost of average inventory during a particular period. It is expressed in number of
times. The Inventory turnover ratio indicates the number of times the stock has been replaced
during the period and evaluates the efficiency with which a firm is able to manage its
inventory. This ratio indicates whether investment in stock is within proper limit or not.

Components of the Ratio:

Average inventory and cost of goods sold are the two elements of this ratio. Average inventory is
calculated by adding the stock in the beginning and at the end of the period and dividing it by two. In
case of monthly balances of stock, all the monthly balances are added and the total is divided by the
number of months for which the average is calculated.

Formula of Stock Turnover/Inventory Turnover Ratio:

The ratio is calculated by dividing the cost of goods sold by the amount of average stock at
cost.
 Inventory Turnover Ratio =

Cost of goods sold ÷ Average inventory at cost

Generally, the cost of goods sold may not be known from the published financial statements. In such
circumstances, the inventory turnover ratio may be calculated by dividing net sales by average
inventory at cost. If average inventory at cost is not known then inventory at selling price may be
taken as the denominator and where the opening inventory is also not known the closing inventory
figure may be taken as the average inventory.

Example:
The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at
cost).

Calculate inventory turnover ratio

Calculation:

Inventory Turnover Ratio (ITR) = 500,000 / 50,000*

= 10 times

This means that an average one dollar invested in stock will turn into ten times in sales

Significance of ITR:
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high
inventory turnover/stock velocity indicates efficient management of inventory because more
frequently the stocks are sold; the lower amount of money is required to finance the inventory. A low
inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover
implies over-investment in inventories, dull business, poor quality of goods, stock accumulation,
accumulation of obsolete and slow moving goods and low profits as compared to total investment.
The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit;
a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied
by relatively high profits. Similarly a high turnover ratio may be due to under-investment in
inventories.

It may also be mentioned here that there are no rule of thumb or standard for interpreting the
inventory turnover ratio. The norms may be different for different firms depending upon the nature of
industry and business conditions. However the study of the comparative or trend analysis of inventory
turnover is still useful for financial analysis.ii
Days Sales in Inventory

Indicates the length of time that it will take to use up the inventory through sales.

Ending Inventory
Cost of Goods Sold ÷ 365

This is a financial measure of a company's performance that gives investors an idea of how long it
takes a company to turn its inventory (including goods that are work in progress, if applicable) into
sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI
varies from one industry to another.iii

i
http://www.accountingformanagement.com/average_costing_method_materials_costing.htm
ii
http://www.accountingformanagement.com/stock_turn_over_ratio.htm
iii
http://www.investopedia.com/terms/d/dsi.asp