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