Inventory, although a current asset, is not specific but instead a valuation. Inventories
are merely stock of goods held for use in production, or for sale or resale. Retailers and
wholesalers have merchandise inventory while manufacturers have several classes of
inventory: raw materials that are used in the manufacturing process; work in process,
goods in production but not yet finished; finished goods, goods finished but not yet sold.
To keep things simple we will use as the basis for this article finished goods, a product.
The inventory equation is:
Beginning Inventory (BI) |
|
| plus |
Units Purchased (P) |
| minus |
Units Sold (S) |
| equals |
Ending Inventory (EI) |
This equation may be better understood using cans as an example. At the beginning of the
year we have 10 cans. During the year we purchase 25 cans and sell 25 of them. How many
are left at the end of the year?
(BI) 10 + 25 - 25 = 10 (EI).
We can see that there should be 10 cans on hand at year end. Let's assume the BI had a
cost of $500 each, and purchases were made in April, June, September and December. In
April we purchase 5 cans at a cost of $600 ea., In June we purchase 10 cans at a cost of
$750 each. In September and December we purchase 5 cans each. September at $800 each and
December at $1000 each. However, the problem is, what is the value of those remaining 10
cans?
There are three common methods of valuing inventories.
WEIGHTED AVERAGE
The weighted average approach assumes that all of our inventory is priced the same
regardless of what it actually cost. To determine the weighted average we simply add up
the total number of units and their costs. We then divide the total cost by the total
number of units and then multiply the remaining balance by the average cost.
FIRST-IN, FIRST-OUT, ( FIFO)
FIFO assumes that the cost of goods at the end of the period is our final cost regardless
of inflation. Five cans were purchased in September at a cost of $4,000 and five cans were
purchased in December at a cost of $5,000. The Ending inventory would therefore be $9,000.
In inflationary times FIFO overstates the inventory value.
LAST-IN, FIRST-OUT, ( LIFO)
LIFO assumes that the beginning price is our final cost of goods.
In the beginning we had inventory of ten cans at a cost of $500. Our ending inventory is
therefore $5,000.
In inflationary times LIFO undervalues inventory.
Depending on the method of valuation used, working capital can be over or under stated
thus having an effect on the net working capital shown on the balance sheet.
For this reason we must always determine what valuation method was employed in
ascertaining the inventory number. This will have even more significance when we evaluate
the income statement. The valuation of inventory can mean the difference between profit
and loss.
I wish you well.
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