Definition: The term ‘inventory‘ implies the goods available with the business enterprise for the purpose of sale. It serves as the excess supply of goods, which is helpful in keeping the operations going, without any delays or shortage of stock. It has three stages:
- Raw Materials: It refers to the unprocessed supply of material, which serves as the main component for the goods to be produced.
- Work-in-Process: Work-in-Process implies the partially completed stock with the organization.
- Finished Goods: As the name signifies, these are the goods ready for sale.
Methods of Inventory Valuation
Method of inventory valuation is used to ascertain the cost of goods sold and the cost of closing the inventory. The methods of ascertaining the cost of inventory are divided into two categories:
Historical Cost Methods
- Specific Identification Method: In this method, the price of goods relies on the physical flow of goods. Specific costs are attributed to the recognizable goods, and it involves keeping various lots bought separately to ascertain the lot whose units in inventories are in hand. The specific purchase price forms the basis for their historical cost.
- FIFO or First in First Out Method: As the name suggests, this method is based on the principle that costs are charged to the revenue in the order of their incurrence. Hence, the issue of goods is made from the very first lot in hand. In this way, the unsold stock of goods comprises of latest lots, as the items of inventories which are bought first are issued first. And, the value of closing inventory is the price paid for the lot.
- LIFO or Last in First Out Method: In this pricing method, the items of the latest lot bought are issued first, and so, the prices of the latest batch are used for pricing the issues, until it is finished. So, if the quantity to be issued is in excess of the latest lot, then the issue will be made first from the latest lot, and the rest from the prior lot, in their respective prices.
- Simple Average Price Method: In this method, the different prices of all the batches are aggregated and then divided by the number of prices, so as to come up with a simple average price for all the lots. In this way, the closing stock is valued at the average price determined.
- Weighted Average Price Method: In this method, the weighted average price is calculated, with the help of quantities bought in batches as weights. First of all, the cost of goods available for sale is ascertained, by multiplying the total units in each lot with the respective prices and then divided by the total number of units available for sale, to arrive at the weighted average price per unit.
Non-Historical Cost Method
- Adjusted Selling Price Method: This method is mainly used in retail business, and so it is called a Retail Inventory method. This is suitable for measuring those inventories, that has a high number of frequently changing items with the same margins. Under this method, the cost of inventory is calculated by reducing the anticipated percentage of margin from the inventory’s sales value.
- Standard Cost Method: On the basis of experience, a standard cost for the inventory is ascertained as per the rapid changes in the price and frequent purchases.
Method of Inventory Valuation plays a very significant role in assigning costs to inventory which is adopted and consistently followed by the organization, concerning the way in which inventory flows in the organization.