When working on inventory valuation, you need to establish:
- The cost of the raw materials issued to production and;
- The value of the stock of raw materials left unused in the stores at the year-end
At the year-end there may be stocks of raw material held in the stores department. The cost of the raw materials will be known from the purchase invoices, but closing stock may be made up of materials delivered at different times and at different prices. This makes it difficult to match the closing stock with the prices paid exactly. It may be extremely time consuming even to try.
Cost accountants have therefore developed three methods for placing a price on material issues from stores, and valuing the closing stock of raw materials.
FIFO (First in, First out)
This inventory valuation method assumes stock issued from stores is taken from the oldest stock held. Issues to production are, therefore, charged at the oldest prices, and the remaining stock is valued at the latest prices.
LIFO (Last in, First out)
This method assumes stock issued from stores is taken from most recent deliveries. Issues to production are, therefore, charged at the latest prices, and the stock remaining in the stores is valued at the older prices.
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AVCO (Average Cost/Weighted Average)
This method charges an average price for issues to production. The total value of stock in the stores is divided by the total number of units in stock, giving an average cost per unit. The average cost is re-calculated each time a new delivery is received.
Each method will value the issues to production differently, which will also then lead to the closing stock being valued differently. As closing stock is used to calculate the cost of sales for a business, the value of the closing stock and method chosen will have a direct effect on the profit of the business – so much so that LIFO as a pricing and inventory valuation method is available for internal (cost accounting) purposes only. In the preparation of the financial accounts IAS 2 does not permit LIFO as a method of inventory valuation.
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