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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

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