3 Introduction to accounting

3.3 Valuation of inventory

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The cost of inventory, in theory, includes all costs incurred to acquire the goods and make them ready for sale. This theoretical cost may include shipping costs, discounts, insurance, receiving costs, handling costs, storage costs, etc.

In practice, the cost used is often limited to the total invoice price for the goods. This formula may or may not include shipping and handling. Other costs are often ignored if they are immaterial to the overall cost of the inventory, if there is no easy way to allocate the costs to the inventory, or they are relatively constant period to period.

Inventory valuation must consider in the following situations:

  • When the valuation of inventory varies from purchase to purchase. The costing method determines the valuation. This situation is automatically handled in LedgerSMB using one of the inventory valuation methods discussed below.

  • When the valuation of inventory is less that what was paid for it. The inventory must be written down. This is usually a manual calculation that is the result of damage, obsolescence, or decline in the vendor or suppliers selling price.

  • When estimates are required, such as when inventory is stolen, destroyed, or when a physical inventory cannot be performed. In this case, a reasonable and consistent manual method must be used to estimate the value.

There are several general automated inventory valuation methods including the following:

  • Specific Identification – Each specific inventory item has its cost tracked individually. This method is usually used for large and expensive items that can be tracked by serial number or identification tag. Typically, the specific identification inventory valuation method results an inventory valuation close to value of using the First in, first out (FIFO) method.

  • FIFO– This method is similar to selling the oldest product first merchandising policy. In the FIFO method the lastest costs are included in inventory cost and the older costs are charged back to COGS.

    FIFO is the preferred method for maintaining accurate historical costs and is less susceptible to income manipulation by the timing of new purchases. Typically FIFO results in the highest inventory value of these methods.

    In LedgerSMB the inventory cost is tracked on a FIFO basis. When a part is purchased, its cost is added to the inventory asset account. When the part is sold, the cost of the item is moved to the cost of goods sold account.
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    @@@TODO What sold cost is used; oldest, newest, average?
    @@@TODO How is the inventory asset account debited?

  • Last in, first out (LIFO)– Under LIFO the costs of the last goods purchased are charged against revenues as the COGS and the inventory is composed of the costs of the oldest goods acquired.

    LIFO is preferred when prices are rising as it typically results in reducing net income and thereby reducing taxes. However, LIFO allows manipulation of income by simply changing the time at which additional purchases are made and does not represent accurate historical costs. Typically LIFO results in the lowest inventory value.

  • Weighted Average – Under the weighted average method, the total number of units purchased plus those on-hand at the beginning of the period is divided by the total costs of purchases plus the cost of the beginning inventory.

    Typically the weighted average inventory valuation method results in an inventory value between FIFO, which is the highest, and LIFO which is the lowest.