4.5 Inventories - 4.5 Inventories Explained

Key Concepts

• Inventory Valuation
• FIFO (First-In, First-Out)
• LIFO (Last-In, First-Out)
• Weighted Average Cost
• Inventory Write-Down

Inventory Valuation

Inventory Valuation refers to the process of determining the cost of goods held for sale by a company. Accurate inventory valuation is crucial for financial reporting, as it affects both the balance sheet and the income statement. The cost of inventory includes all costs incurred to bring the goods to their present location and condition.

Example: A retail store buys 100 units of a product at $10 each. The total cost of inventory is $1,000. If the store sells 50 units, the cost of goods sold (COGS) and the remaining inventory need to be accurately calculated.

FIFO (First-In, First-Out)

FIFO is an inventory valuation method where the first items purchased are the first ones sold. This method assumes that the oldest inventory is sold first, and the remaining inventory consists of the most recently purchased items. FIFO is commonly used in industries where products have a limited shelf life.

Example: A bakery buys 100 loaves of bread on Monday at $1 each and 100 loaves on Tuesday at $1.20 each. If 150 loaves are sold by Wednesday, under FIFO, the first 100 loaves at $1 each and 50 loaves at $1.20 each are considered sold. The remaining inventory is valued at $1.20 each.

LIFO (Last-In, First-Out)

LIFO is an inventory valuation method where the most recently purchased items are the first ones sold. This method assumes that the newest inventory is sold first, and the remaining inventory consists of the oldest items. LIFO is often used in industries with stable or increasing prices to reduce taxable income.

Example: Using the same bakery example, under LIFO, if 150 loaves are sold by Wednesday, the 100 loaves bought on Tuesday at $1.20 each and 50 loaves bought on Monday at $1 each are considered sold. The remaining inventory is valued at $1 each.

Weighted Average Cost

Weighted Average Cost is an inventory valuation method where the average cost of all items in inventory is used to determine the cost of goods sold and the value of remaining inventory. This method smooths out the impact of price fluctuations.

Example: Using the bakery example, the weighted average cost per loaf is calculated as [(100 loaves * $1) + (100 loaves * $1.20)] / 200 loaves = $1.10 per loaf. If 150 loaves are sold, the COGS is 150 * $1.10 = $165, and the remaining inventory is valued at 50 * $1.10 = $55.

Inventory Write-Down

Inventory Write-Down occurs when the value of inventory is reduced to its net realizable value (NRV), which is the estimated selling price minus the costs of completion and disposal. This adjustment is made when the market value of inventory falls below its cost.

Example: A clothing store buys 100 jackets at $50 each. Due to a sudden change in fashion, the market value of the jackets drops to $30 each. The store writes down the inventory by $20 per jacket, reducing the value of the inventory from $5,000 to $3,000.