Chapter 8
Inventory Valuation
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For example, suppose that Tools 4U purchased 10 steel hammers for $20 each as inventory in
March. When one of these hammers is sold to a customer, inventory must be credited for $20
and COGS must be debited for $20. Due to an increase in the price of steel, Tools 4U must pay
$25 per hammer in April. Now it has a mix of identical hammers, some of which cost $20 and
some of which cost $25. When a hammer is sold during April, which cost should be used to
update inventory and COGS? Ideally, it would be possible to tell which hammers came from which
shipment, but the costs and effort of tracking such information often outweigh the benefits.
There are three methods that companies can use, based on the nature of the goods, to determine
how inventory costs are handled.These are called
inventory valuation methods
because they will
determine the value of inventory on hand at any given time.The three methods used in Canada are
specific identification, first-in, first-out, and weighted-average cost.
• The
specific identification
method is used when a business sells goods which are not identical
or are customized in some way.This method accurately tracks the costs and value of inventory,
but it can be costly to apply. Highly valuable items such as cars, houses, and diamonds are often
valued under this method.
• The
first-in, first-out (FIFO)
method is used when a business assumes that the first items
received in inventory are also the first items moved out of inventory. Perishable items that
expire within a relatively short period of time, such as fruit and vegetables, are often valued
under this method.
• The
weighted-average cost
method is used when a business simply applies an average cost
to all of the units of a particular inventory item. Homogenous (standardized) materials, such
as plastic used in the making of garbage bags, or oil used in making gasoline, are often valued
under this method.
The method chosen does not need to perfectly match the actual physical movement of goods. For
example, if a business chooses the FIFO method to value its lawn chairs, it is still acceptable to sell
newer lawn chairs before older ones in the course of business. Once a valuation is chosen however,
accounting standards dictate that the business must use it consistently unless a change can be
properly justified.This is done to
stop businesses from arbitrarily
changing inventory valuation
methods for the purpose of
manipulating the values of
COGS and ending inventory.
Applying Valuation Methods
Cool Ink Company sells a number of different high quality pens, pencils, markers and highlighters.
Let us examine one item from its inventory to illustrate the three different inventory valuation
methods. Assume that Cool Ink uses a perpetual inventory system to account for purchases and sales.
Cool Ink Company currently has ten collector pens in inventory with a cost of $10 each. During
the month of March, the following transactions took place with respect to collector pens which is
shown in Figure 8.1.
The principle of consistency prevents businesses from changing
accounting methods for the sole purpose of manipulating figures
on the financial statements.
WORTH REPEATING
