Inventory valuation models and profitability
In order to value inventory, there is a physical count of inventory that takes place at the end of the year which can be a tedious task. This is because even though a business may have an inventory where all the units are identical, the prices on these units could vary. Some units could be priced higher than others due to increases in price over time or due to changes in the suppliers.
Businesses generally sell and value their inventory in a systematic way. The ways in which they could do this is as follows:
- Sell the inventory they received first, first
- Sell the inventory they received last, first or
- Sell the inventory they have in any order and value it based on the average of prices.
These systems for valuing inventory are called First-In-First-Out (FIFO), Last-In-First-Out (LIFO) and Average Cost (AVCO) methods respectively. They would generate three different values for inventory at the end of the year. We will discuss each of these systems below.
First let us consider that during the year we made the following sales and purchases of inventory:
5 units @ $20 each
10 units @ $18 each
5 units @ $19 each
Figure 1: Inventory Table
Now let us consider how the stock will be valued at the end of September under each of these valuation methodologies:
Recall again that under the FIFO method the inventory that was received first will be sold first. In June, we are informed that 3 units were sold. Under FIFO this means that these units were from among the units purchased at $20 per unit. In August we sold an additional 10 units. This would mean that 2 of these units came from those remaining of the May purchase (at a cost of $20/unit) and the other 8 were from those purchased on July costing $18/unit.
At the end of September we are therefore left with an inventory of the remaining 2 units from the July purchase which cost us $18/unit = $36 and 5 units from the September purchase that cost us $19/unit = $95. The total closing inventory at the end of September is $36 +$95 = $131.
Under LIFO method, we sell the latest inventory first. In June we sold 3 units which came from the latest stock purchased as of this date. This was the stock purchased in May valued at a cost of $20 per unit. In August we sold 10 units. Again this sale is from the latest stock purchase at that date, which was the stock purchased in July valued at a cost of $18/unit.
At the end of September we will be left with the inventory of: 2 units from the May purchase of $20/unit = $40 and 5 units from the September purchase of $19/unit = $95. The total closing inventory at the end of September is $40 + $95 = $135.
Under the AVCO methodology the timing of the purchase of inventory does not come into play when deciding which units to sell first. Instead every time there is a purchase of units of inventory the average cost per unit would need to be adjusted.