Inventory Cost Valuation

Inventory is a vital asset of a company, especially for merchandising and manufacturing. It is the goods which the company resell, or materials used in processing products to be sold and gain profit. Inventory turnover is quite frequent for these companies, and their purchase price are not always the same. In order to identify the cost of inventory and cost of goods sold, inventory valuation shall be used.

There are four methods of inventory costing, this includes: Specific Identification, First-In First-Out (FIFO), Last-In First-Out (LIFO) and Weighted Average Method.

This is a process of identifying actual cost for each specific product upon purchase and applying the cost to the actual product sold. It is more practicable to use when the individual inventory items that are easily identifiable and has a significant value that is material for each valuation purposes.

Example is when you purchase Item A on June 1 for ₱1,000.00, Item B on June 15 for ₱1,500.00, and Item C on June 30 for ₱2,000.00. Upon Sale on July 1, the item sold is pertaining to Item B. In this example, the cost of ending inventory shall be attributable to Item A and Item C for a total of ₱3,000.00. This method requires detailed physical count of the ending inventories and their specific purchase price.

FIFO assumes that inventory purchased first shall be disposed first, as the name suggests. For some companies, they actually sell the items purchased first in order to avoid losses from spoilage or depreciation. Assuming on the same example, the method assumes that the company first sell item A and not item B since the company purchased item A first. Therefore the ending inventory shall be ₱3,500.00, which is the total amount of the last 2 items purchased.

In this method, the cost of the most recent purchase shall be applied first to the cost of the actual goods sold. Assuming on the same example for Specific Identification Method, instead of selling Item B on July 1, the company shall apply the cost of Item C which was the most recent purchased. The value of ending inventory therefore is ₱ 2,500.00 (₱1,000.00 + ₱1,500.00). This method is no longer permitted in PFRS.

This is recommended when inventory items are not easily identifiable. The cost of ending inventory is measured by computing the weighted-average cost per unit and applying it to the number of units left in the inventory. Example is when you purchase 5 units on June 1 for ₱1,000.00, 3 units on June 15 worth ₱600.00; the cost per unit is equivalent to ₱200 per unit which is computed by dividing the total goods available for sales (₱ 1,600) by the unit available for sale (8units).

Assuming you sold 3 units, the remaining amount is ₱ 1,000.00 (₱ 200/unit x 5 units left).

After choosing the appropriate valuation method, you can now apply this on to the computation of cost of goods sold. This is different for Merchandising and Manufacturing as follows:

The formula is in computing for the cost of goods sold in merchandising company is straight forward. Total purchase for the period shall be added to the beginning inventory less the cost of inventory at the end of the period. Total purchases includes the cost of purchase, freight in, and less of purchase discount, if any.

For Manufacturing Companies, inventories are classified into Raw Materials, Work in Process, and Finished Goods. Raw materials are the initial form of items purchased that is subject to conversion which in turn transfers to Work in Process. Once the processed items are finally completed, it will be transferred to finished goods inventory and is available for sale. Whatever is sold from the finished goods inventory will form part of the cost of goods sold.

The value of inventory will matter on the inventory valuation you choose and consequently affects the profitability structure. It is best to seek advice from accounting experts for the appropriate methods to apply in order to get the desired result for valuation in properly aligning the cost structure of the business.