Valuation of Inventories
What is Valuation of Inventories?
Assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
Key formula / rule: Weighted Average Cost (per unit)
Key points
- Define inventory and its types.
- Explain the importance of inventory valuation.
- Understand and apply the 'lower of cost or NRV' rule.
- Calculate inventory value and COGS using FIFO and Weighted Average methods.
Common exam trap
Confusing the calculation logic between FIFO and LIFO methods.
Definitions
- Term
Inventory
- Meaning
Assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
- Term
Cost of Inventory
- Meaning
Comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
- Term
Net Realizable Value (NRV)
- Meaning
The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
- Term
FIFO (First-In, First-Out)
- Meaning
An inventory valuation method that assumes the first units purchased or produced are the first ones sold. Consequently, closing inventory is valued at the cost of the most recently purchased or produced units.
- Term
Weighted Average Method
- Meaning
An inventory valuation method that calculates the average cost of all goods available for sale and applies this average cost to both the cost of goods sold and the ending inventory.
Learning objectives
Define inventory and its types.
Explain the importance of inventory valuation.
Understand and apply the 'lower of cost or NRV' rule.
Calculate inventory value and COGS using FIFO and Weighted Average methods.
Analyze the impact of different inventory valuation methods on financial statements.
Formulae
- Name
Weighted Average Cost (per unit)
- Note
This average cost is then applied to both units sold (COGS) and units remaining (Closing Inventory).
- Expression
(Cost of Opening Inventory + Cost of Purchases) / (Units in Opening Inventory + Units Purchased)
- Name
Net Realizable Value (NRV)
- Note
Inventory is valued at the lower of its cost or NRV.
- Expression
Estimated Selling Price - Estimated Costs of Completion - Estimated Costs Necessary to Make the Sale
- Name
Cost of Goods Sold (COGS)
- Note
This is a general formula; the specific cost of purchases and closing inventory will depend on the valuation method used.
- Expression
Opening Inventory + Purchases - Closing Inventory
Prerequisites
Basic understanding of accounting principles (e.g., matching principle, prudence concept, going concern).
Knowledge of financial statements (Income Statement, Balance Sheet).
Basic arithmetic and calculation skills.
Common mistakes
Confusing the calculation logic between FIFO and LIFO methods.
Failing to apply the 'lower of cost or NRV' rule correctly.
Incorrectly calculating the weighted average cost, especially when new purchases occur.
Ignoring opening inventory when calculating COGS or closing inventory.
Not understanding the impact of each method on profit and tax during inflation/deflation.
Keywords
Inventory
Valuation
FIFO
LIFO
Weighted Average
Cost of Goods Sold
Closing Stock
Net Realizable Value
AS 2
Accounting Standards
Practice preview
A business had an opening inventory of 200 units at Rs. 50 each. It then purchased 300 units at Rs. 55 each and later 100 units at Rs. 60 each. If 450 units were sold, what is the value of the closing inventory using the…
medium
According to accounting standards (e.g., Ind AS 2), inventories should be valued at which of the following?…
easy
What is the primary purpose of valuing inventories at the end of an accounting period?…
easy