Meaning of inventory costing
Inventory means goods- be it complete or even incomplete, for sale, or for own use of a business entity at any point in time. It consists of three elements- raw materials to be used for the production process, work-in-progress or incomplete goods in the production process, and finally, finished products- be it for sale or own consumption of the business entity. It is a current asset for a body and is assumed to be converted into money within the next year. Inventory costing is the process of assigning a monetary value to the inventory in the hand of a business entity at any point in time.
Proper inventory costing is essential for any business as it directly affects the COGS (Cost of Goods Sold). It, in turn, will affect the gross profit of the entity and, eventually, its taxable income. Therefore, inventory costing is essential and will directly affect the preparation of all the critical financial statements of an entity, which could be an income statement and the Balance Sheet.
Different inventory costing methods can give different values of inventory in hand. If a technique assigns a high value to inventory, the cost of goods sold will go down. The gross profit will go up, and hence, taxable income will also go up. On the other hand, if a method assigns a lower value to inventory, the cost of goods sold will go up. The gross profit will go down, and hence, the taxable income will also go down.
Methods of inventory costing
There are four critical methods for inventory costing.
Specific identification method
The cost of every component of inventory is tracked explicitly in this method. The cost of goods sold and closing stock are calculated after that. Since this method is very elaborate, it can be used only with large items such as cars or items which are unique and of high value. In most cases, it is difficult to assign a cost to each component of the inventory. Hence, this method is not preferred.
First in First Out method
In this method, the assumption is that the items first purchased will be consumed first. This method is the most logical and rational of all. It is so because inventory is used like this only in most organizations. It also means that the items remaining in the stock are those bought latest.
The closing stock will be of higher value in times of rising prices. It means that the Cost of Goods sold will be lesser. Therefore, gross profit will be higher, and so will be the taxable income under this method.
For a detailed article, refer to FIFO.
Last in First Out method
This method is the opposite of FIFO. The assumption is that the items in the inventory an entity purchases last are of use first. Thus, items in closing stock will be those purchased in the beginning. It is against the general policy of consuming items. Therefore this method is less preferred for inventory costing.
In times of rising prices, items an entity buys at a higher rate later will be used first. It means that the Cost of Goods sold will go up. Gross profits will fall, and so will the taxable income. Items in the closing stock are valued at older, lesser rates. Therefore it will be of lower value.
Refer to LIFO Liquidation for more details.
Weighted average method
The value of inventory keeps constantly changing under this method. The weighted average rate is worked out at the time of purchase of a new item. The Cost of Goods sold, gross profit, and closing stock values are calculated by this average cost.
Example of inventory costing
Let us assume that ABC Pvt. Ltd. manufactures biscuits.
The first inventory is 3000 units @ US$2 per unit.
The production for the next three months is 2000 units per month.
And the input costs are rising.
The produce is worth $2.25, $2.5, and $2.75 per unit, respectively, for the three months.
Sales for the period have been 7000 units, and closing stock at hand is 2000 units. The selling price for each unit is US$4.
Sales- 7000 units x 4= US$28000.
Total production- 2000 units x 2.25 + 2000 units x 2.5 + 2000 units x 2.75= US$15000.
If we use the specific identification method, it would be practically impossible to work out the costing and correctly allocate it as input costs have been rising continuously.
Let us see how the numbers work out under FIFO. The first units in hand are the first to sell.
Hence, Cost of Goods sold- (3000 units x 2 + 2000 units x2.25 + 2000 units x2.5)= US$15500.
Closing Stock- 2000 units x 2.75= US$5500.
Gross profit- $28000 – $15500= US$12500
In the case of LIFO
The units last produced will be sold first. The12 units from the beginning will be the closing stock.
Cost of Goods Sold- (2000 units x 2.75 +2000 units x 2.5 +2000 units x 2.25 + 1000 units x 2)= US$17000
Closing Stock = 2000 units x 2= US$4000
Gross Profit = $28000 – $17000= US$11000
Weighted Average method
In this method, we will take the weighted average of all the units and their prices. Then the weighted average cost is taken to calculate the Cost of Goods Sold and the closing stock.
Weighted Average = (3000units x 2 + 2000 units x 2.25 +2000 units x 2.5 + 2000 units x 2.75) / 9000 units = 21000/9000= $2.33 per unit
Cost of Goods Sold = 7000 units x 2.33= US$ 16330
Closing Stock = 2000 units x 2.33= US$4670
Gross Profit = $28000- $16310= US$11690.
From the above example, we can interpret the following:
- If the prices of inputs are constant, all the three methods will give the same Cost of Goods Sold and the closing stock.
- During inflationary trends in the economy, i.e., with continuously increasing prices, the Cost of Goods Sold will be lowest under FIFO and highest under LIFO. It will be somewhere in between under the weighted-average method.
- Accordingly, the closing stock will be highest under FIFO, lowest under LIFO, and somewhere in between under the weighted-average method.
- Inventory costing affects the gross profits and, thus, the taxable income and the taxes a company has to pay. In the above example, gross profit and taxes will be highest under FIFO, in the middle under the weighted average method, and lowest under LIFO.
- During deflationary trends in the economy, i.e., with continually decreasing prices, all the above parameters will be vice-versa.
- The management needs to identify which method suits their organization. The method chosen has to be disclosed at the time of preparation of final accounts. Inventory is part of the Current Assets of a company. Therefore, its valuation figures will also have an impact on various financial ratios, which are arrived at by using current assets.
- The management has to judiciously choose an inventory costing method as it also affects its profits, income, and taxation figures. These figures will be of importance to stakeholders such as investors and regulatory authorities. Moreover, they will be relevant to the management itself for decision-making.