Various methods of valuation of inventories

 

Methods of valuation of inventories first in first out ( commonly called fifo):

  

   Under this method material is first issued from the earliest consignment on hand and priced at the cost at which that consignment was placed in the stores.

  In other words, materials received first are issued first. The units in the opening stock of materials are treated as if they are issued first, the units from the first purchase issued next, and so on until the units left in the closing stock of materials are valued at the latest cost of purchases.

   It follows that unit costs are apportioned to cost of production according to their chronological order of receipts in the store.

   This method is most suitable in times of falling prices because the issue price of materials to jobs or works orders will be high ( materials issued from the earliest consignments which were purchased at a higher rate ) while the cost of replacement of materials will be low.

  But in case of rising prices this method is not suitable because the issue price of materials to production will be low while the cost of replacement of materials will be high.

Advantages of FIFO method:

1. The main advantage of FIFO method is that it is simple to understand and easy to operate.

2 It is a logic method because it takes into consideration the normal procedure of utilising first those materials which are received first.

  Materials are issued in order of purchases, so materials received first are utilised first.

3 Under this method, materials are issued at the purchase price., So the cost of materials is concerned. Thus the method recovers the cost price of the materials.

4 Closing stock of materials will be valued at the market price as the closing stock under this method would consist of recent purchase of materials.

6 This method is also useful when transactions are not too many and prices of materials e fairly steady.

Disadvantages of FIFO method:

1 This method increases the possibility of clerical errors, if consignments are received frequently at fluctuating prices as every time an issue of materials in made , the store ledger clerk will have to go through this record to ascertain the price to be charged.

2 In case of fluctuations in prices of materials, comparison between one job and the other job becomes difficult because one job started a few minutes later than another of the same nature may be issued materials at different prices, merely because the earlier job exhausted the supply of the lower priced materials in stock.

3 For pricing one requisition more than one price has often to be taken.

4 When prices rise, the issue price does not reflect the market prices as materials are issued from the consignments.

   Therefore, the charge to production is low because the cost of replacing the material consumed will be higher than the price of issue.

Last in first out ( Commonly Called LIFO ) method:

  As against the First in first out method the issues under this method are priced in the reverse order of purchase i.e., the price of the latest available consignment is taken.

  This method is sometimes known as the replacement cost method because materials are issued at the current cost to jobs or work orders expert when purchases were made long ago.

   This method is suitable in times of rising prices because material will be issued from the latest consignment at a price which is closely related to the current price levels.

   Valuing material issues at the price of the latest a available consignment will help the management in fixing the competitive selling prices of the products.

  This method was first introduced in the U.S.A during the second world war to get the advantages of rising prices.

Advantages of LIFO method:

1 Like FIFO method, this is simple to operate and is useful when transactions are not too many and the prices are fairly steady.

2 Like FIFO, this method recovers cost from production because actual cost of materials is charged to production.

3 Production is charged at the recent prices because materials are issued from the latest consignment.

  Thus, effect of current market prices of materials is reflected in the cost of sales provided the materials are recently purchased.

4 In times of rising prices LIFO method of pricing issues is suitable because materials are issued at the current market prices which are high.

   This method thus helps in showing a lower profit because of increased charge to production during periods of rising prices and lower profit reduces burden of income - tax.

Disadvantages of LIFO method:

1 Like FIFO,this method may lead to clerical errors as every time an issue is made, the store ledger clerk will have to go through the record to ascertain the price to be charged.

2 Like FIFO, comparison between one job and the other job will become difficult because one job started a few minutes after another of the same type may bear a different charge for materials consumed, merely because the earlier job exhausted the supply of the lower priced or higher priced materials in stock.

3 For pricing a single requisition, more than one price has often to be adopted.

4 The stock in hand is valued at price which does not reflect current market price. 

  Consequently, closing stock will be understated or overstated in the Balance Sheet.

Average cost method:

   The principal on which the average cost method is based is that all of the materials in store are so mixed up that an issue cannot be made from any particular lot of purchases and, therefore, it is proper if the materials are issued at the average cost of materials in store. Average may be of two types:

(1) Simple Arithmetic Average

(2) Weighted Arithmetic Average.

(1) Simple Arithmetic Average:- 

" A price which is calculated by dividing the total of the prices of the materials in the stock from which the material to be priced could be drawn by the number of the prices used in that total ".

  Simple average price is calculated by dividing the total of unit purchase prices of different lots in stock on the date of issue by the number of prices used in the calculation and quantity of different lots is ignored.

This method may lead to over - recovery or under - recovery of cost of materials from production because quantity purchased in each lot is ignored.

  Simple average price is not be followed because this method of calculating issue price does not recover the cost price of the materials from the production.

(2) Weighed Average Price :- 

" A price which is calculated by dividing the total cost of materials in the stock from which the materials so be priced could be drawn by the total quantity of materials in that stock ".

  It is better to issue the material at weighted average price method because it recovers the cost price of the materials from production.

Advantages:-

1. This method is rational, systematic and not subject to manipulate.

  It is representative of the prices that prevailed during the entire period rather than of the price at the beginning, end , or at one point of issue during the period because it is based on the average of the material costs of the various lots available in the store.

2. Average price method is considered to be the best method when prices fluctuate considerably because this method tends to smooth out fluctuations in prices.

3. Issue prices are not to be calculated each time issues are made. Issue prices are changed only when new lot of materials is received .

4. This method recovers the cost of materials from production.

5. This method maintains the issue prices as near to the market price possible.

6. This method eliminates the necessity for adjustments in stock valuation.

Disadvantages:-

1 The greatest disadvantage of this method is that a fresh rate calculation will have to be made as soon as a new lot of materials is purchased which may involve tedious calculations thus, there are chances of clerical errors.

2 Issue price of materials does not represent actual cost price of materials issued but it represents average cost of materials in stores.

 At the time of rising prices, it over- states profit but not as much as FIFO because average price is lower than the most recent price.

3 Closing stock is not valued at current cost.

  It is the average cost method which is mostly used by different organisations because it satisfies most of the conditions of a good method of valuing material issues.

Inflated price method:-

  There are some materials which are subjected to natural wastage.

Example are:

(1) material list due to loading and unloading and

(2) timber lost due to seasoning. In such cases, the materials are issued at an inflated price ( a price higher than the actual cost) so as to recover the cost of natural wastage of materials from the production. In the way, the total cost of the material is recovered from the production.

Specific price or identification method:-

Under this method, materials issued to production are priced at their purchase prices.

  The basic assumption in the following this method is that materials in the stores are capable of being identified as belonging to specific lots.

Identification can be made by placing some distinguishing mark usually price tag on every lot. When materials are not issued, price tags are removed and forwarded to the costing department for ascertaining the material cost of production. This method is simple in its mechanism and operation.

Base stock method:-

Each concern always maintains a minimum quantity of material in stock.

  This minimum quantity is known as safety or base stock and this should be used only when an emergency arises. The base stock is created out of the first lot of the material purchased and, therefore, it is always valued at the cost price of the first lot and is carried forward as a fixed asset.

  This method works with some other method and is generally used with FIFO or LIFO method. 

  Therefore the advantages or disadvantages of the method. ( With which the base stock method is used) will arise. Any quantity over and above the base stock is issued in accordance with the other method which is used in conjunction with this method. The objective of this method is to issue the material according to the current prices. This objective will be achieved only when the LIFO method is used together with the base stock method.

Highest in first out (HIFO) method:-

 This method is based on the assumption that the closing stock of materials should always remain at the minimum value; so the issues are priced at the highest value of the available consignments in the store. The method is not popular as it always undervalues the stock which amounts to creating a secret reserve. The method is mainly used in case of cost plus contracts or monopoly products as it is helpful in increasing the price of the contract or products.

Market price method:-

  Market price can either be the replacement price or the realisable price. The replacement price is used in case of the items which are held in stock for use in production while realisable price is used in respect of the items which are kept in stock for sale. Under this method materials are issued at a price at which they can be replaced.

  Therefore, cost of the materials issued is not considered but materials are issued at the market price prevailing on  the date of issue. This method is considered to be the best method where quotations have to be sent because quotations sent would reflect the latest. Competitive conditions so far as materials are concerned.

  This method discloses whether the buying is efficient or ineffecient. There will be efficiency in buying if the market price is higher than the cost price and inefficiency if reverse is the case.