# Small Business Accounting: Inventory Valuation models and profitability: Working Example

In our previous post we covered the three basic inventory valuation models. We now illustrate a simple example of the average cost model in the table below:

 Bought Sold Average cost per unit May 5 units @ \$20/unit \$20 Jun 3 units costing \$20 each Jul 10 units @ \$18/unit [(2×20) + (10×18)]/12 = \$ 18.33 Aug 10 units costing \$18.33 each Sep 5 units @ \$19/unit [(2×18.33)+(5×19)]/7 = \$ 18.81

Figure 2: AVCO example

In May the inventory comprised of 5 units of the product that were purchased in May at \$20 per unit. The average cost per unit therefore was \$20. In June 2 units were sold. These would be value at a cost of \$20.

In July an additional 10 units were purchased at \$ 18/unit. The average cost of the inventory at this point in time is the weighted average cost of the remaining two units from the May purchase and the 10 units purchased in July. This works out to \$18.33/ unit. The ten units sold in August each would be valued at a cost of \$18.33.

In September an additional 5 units were purchased at \$19/unit. The average cost of the inventory at this point in time is the weighted average cost of the remaining 2 units from the prior inventory valued at a cost of \$18.33 each and 5 units purchased in September valued at a cost of \$19 each. This works out to \$18.81 per unit or a total closing inventory at the end of September of \$131.6667 (=18.81 x 7).

You can see that these three methods give us different values for the closing inventory. This in turn impacts the profit that is reported in the income statement- the profit varies based on the chosen method. It is therefore important for an entity to use the method which most closely reflects the nature of its business.

Let us consider another example:

Following are the transactions for the month of May relating to the inventory of Smith who sells two different kinds of mobiles; A and B. You are required to calculate the value of closing inventory using FIFO, LIFO and AVCO and the gross profit under each of these methods.

 Bought Sold 2010 \$ 2010 \$ 1 May 10 units of mobile A @ \$100/unit 1,000 3 May 3 units of mobile B @ \$175/unit 525 2 May 10 units of mobile B @ \$150/unit 1,500 6 May 5 units of mobile A @ \$120/unit 600 12 May 5 units of mobile A @ \$90/unit 450 17 May 10 units of mobile B @ \$180/unit 1,800 15 May 5 units of mobile B @ \$155/unit 775 18 May 7 units of mobile A @ 125/unit 875 23 May 7 units of mobile A @ \$105/unit 735

Figure 3: Smith’s inventory transactions for May

Let us first calculate the closing inventory using each of the methods:

FIFO:

Mobile A

 Date Bought Sold (cost) Inventory after each transaction \$ \$ 1 May 10 units @ \$100/unit 10 units @ \$100/unit 1,000 6 May 5 units @ \$100/unit 5 units @ \$100/unit 500 12 May 5 units @ \$90/unit 5 units @ \$100/unit 5 units @ \$90/unit 500 +450 950 18 May 5 units @ \$100/unit 2 units @ \$90/unit 3 units @ \$90/unit 270 270 23 May 7 units @ \$105/unit 3 units @ \$90/unit 7 units @ \$105/unit 270 +735 1,005

Figure 4: FIFO valuation for Mobile A

Mobile B

 Date Bought Sold (cost) Inventory after each transaction \$ \$ 2 May 10 units @ \$150/unit 10 units @ \$150/unit 1,500 3 May 3 units @ \$150/unit 7 units @ \$150/unit 1,050 15 May 5 units @ \$155/unit 7 units @ \$150/unit 5 units @ \$155/unit 1,050   +775 1,825 17 May 7 units @ \$150/unit 3 units @ \$155/unit 2 units @ \$155/unit 310

Figure 5: FIFO valuation for Mobile B

The closing inventory under FIFO will be \$1,005 + \$310 = \$1,315.

LIFO:

Mobile A

 Date Bought Sold (cost) Inventory after each transaction \$ \$ 1 May 10 units @ \$100/unit 10 units @ \$100/unit 1,000 6 May 5 units @ \$100/unit 5 units @ \$100/unit 500 12 May 5 units @ \$90/unit 5 units @ \$100/unit 5 units @ \$90/unit 500 +450 950 18 May 5 units @ \$90/unit 2 units @ \$100/unit 3 units @ \$100/unit 300 300 23 May 7 units @ \$105/unit 3 units @ \$100/unit 7 units @ \$105/unit 300 735 1,035

Figure 6: LIFO valuation for Mobile A

Mobile B

 Date Bought Sold (cost) Inventory after each transaction \$ \$ 2 May 10 units @ \$150/unit 10 units @ \$150/unit 1,500 3 May 3 units @ \$150/unit 7 units @ \$150/unit 1,050 15 May 5 units @ \$155/unit 7 units @ \$150/unit 5 units @ \$155/unit 1,050 +775 1,825 17 May 5 units @ \$155/unit 5 units @ \$150/unit 2 units @ \$150/unit 300

Figure 7: LIFO valuation for Mobile B

The value of closing inventory under LIFO would be \$1,035 + \$300 = \$1,335.

AVCO:

Mobile A

 Bought Sold (cost) Average cost per unit 2 May 10 units @ \$100/unit \$100 6 May 5 units costing \$100 each 12 May 5 units @ \$90/unit [(5×100) + (5×90)]/10 = \$95 18 May 7 units costing \$95 each 23 May 7 units @ \$105/unit [(3×95)+(7×105)]/10 = \$102

Figure 8: AVCO valuation for Mobile A

The closing inventory consists of 10 units of Mobile A valued at a cost of \$102 each, or \$1020.

Mobile B

 Bought Sold (cost) Average cost per unit 1 May 10 units @ \$150/unit \$150 3 May 3 units costing \$150 each 15 May 5 units @ \$155/unit [(7×150) + (5×155)]/12 = \$152.083 17 May 10 units costing \$152.083 each

Figure 9: AVCO valuation for Mobile B

The closing inventory consists of 2 units of Mobile B valued at a cost of \$152.083 each, or \$304.

Therefore, the total closing inventory for Smith under AVCO is \$1020 + \$304 = \$1324.

The comparative income statement below shows the gross profit under each method:

 Income statement FIFO LIFO AVCO \$ \$ \$ \$ \$ \$ Sales 3,800 3,800 3,800 Purchases 4,460 4,460 4,460 Less: closing stock (1,315) (1,335) (1,324) Cost of inventory sold 3,145 3,125 3,136 Gross profit 655 675 664

Figure 10: Income Statement