First in first out (FIFO) method Last in first out (LIFO) method

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First in first out (FIFO) method Last in first out (LIFO) method

Transcript Of First in first out (FIFO) method Last in first out (LIFO) method

Stock Valuation
First in first out (FIFO) method
The first in first out (FIFO) method of costing is used to introduce the subject of materials costing. The FIFO method of costing issued materials follows the principle that materials used should carry the actual experienced cost of the specific units used. The method assumes that materials are issued from the oldest supply in stock and that the cost of those units when placed in stock is the cost of those same units when issued. However, FIFO costing may be used even though physical withdrawal is in a different order.
Advantages of First in First out (FIFO) Costing Method:
1. Materials used are drawn from the cost record in a logical and systematic manner. 2. Movement of materials in a continuous, orderly, single file manner represents a condition
necessary to and consistent with efficient materials control, particularly for materials subject to deterioration, decay and quality are style changes.
FIFO method is recommended whenever:
1. The size and cost of units are large. 2. Materials are easily identified as belonging to a particular purchased lot. 3. Not more than two or three different receipts of the materials are on a materials card at one
Last in first out (LIFO) method
The last in first out (LIFO) method of costing materials issued is based on the premise that materials units issued should carry the cost of the most recent purchase, although the physical flow may actually be different. The method assumes that the most recent cost (the approximate cost to replace the consumed units) is most significant in matching cost with revenue in the income determination procedure.
Under LIFO procedures, the objective is to charge the cost of current purchases to work in process or other operating expenses and to leave the oldest costs in the inventory. Several alternatives can be used to apply the LIFO method. Each procedure results in different costs for materials issued and the ending inventory, and consequently in a different profit. It is mandatory, therefore, to follow the chosen procedure consistently.
Advantages of Last In First Out (LIFO) Method:
The advantages of the last in first out method are:
Materials consumed are priced in a systematic and realistic manner. It is argued that current acquisition costs are incurred for the purpose of meeting current production and sales requirements; therefore, the most recent costs should be charged against current production and sales. Unrealized inventory gains and losses are minimized, and reported operating profits are stabilized in industries subject to sharp materials price fluctuations.

Inflationary prices of recent purchases are charged to operations in periods of rising prices, thus reducing profits, resulting in a tax saving, and therewith providing a cash advantage through deferral of income tax payments. The tax deferral creates additional working capital as long as the economy continues to experience an annual inflation rate increase.
Disadvantages of the LIFO Costing Method:
The disadvantages or limitations of the last in first out costing method are:
1. LIFO is not deemed an acceptable stock valuation based on International Accounting Standards
2. Record keeping requirements under this method, as well as FIFO, are substantially greater than those under alternative costing and pricing methods.
3. Inventories may be depleted due to unavailability of materials to the point of consuming inventories valued at older or perhaps the oldest prices. This situation will create a miss matching of current revenue and cost, sometimes companies using this costing method counteract this problem by establishing an allowance for replacement of the LIFO inventory account. Cost of goods sold is charged with current cost. The allowance account is credited for the access of the current replacement cost over the LIFO carrying cost for the inventory temporarily liquidated. When this inventory is replenished, the temporary allowance (credit) is removed and the goods acquired are placed in inventory at their old last in first out cost.
Average Cost
Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or label each materials item with an invoice price in order to identify the used units with its acquisition cost. It may be reasoned that units are issued more or less at random as for as the specific units and the specific costs are concerned and that an average cost of all units in stock at the time of issue is satisfactory measure of materials cost. However, average costing may be used even though the physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items low in unit cost and especially if prices are subject to frequent changes.
Advantages of Average Costing Method:
Average costing method has the following main advantages:
1. It is a realistic costing method useful to management in analyzing operating results and appraising future production.
2. It minimizes the effect of unusually high or low materials prices, thereby making possible more stable cost estimates for future work.
3. It is practical and less expensive perpetual inventory system.
The average costing method divides the total cost of all materials of a particular class by the number of units on hand to find the average price. The cost of new invoices is added to the total in the balance column; the units are added to the existing quantity; and the new total cost is divided by the new quantity to arrive at the new average cost. Materials are issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed when materials are returned to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems

sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain
unchanged. When a new purchase is made and a new average is computed, the discrepancy created by the returns will be absorbed.i

Using the information provided by John Doe, we can compute the value of closing inventory, based on the three inventory valuation methods discussed:

Date 1-Aug 8-Aug 16-Aug 20-Aug

Purchases 120 units @ $120 50 units @ $125 20 units @ $140 30 units @ $150

Date 6-Aug 10-Aug 25-Aug

Sales 100 units @ $140 55 units @ $145 40 units @ $160

*Note: Only the quantity under the sales column is relevant for inventory valuation. The Sales prices of $140, $145 and $160 are relevant for determining Total Sales.

Using all three methods we observe that the quantity of closing inventory remains the same. However, the value will differ based on the method being used. We can compare all three methods using a Trading Account as illustrated on the next page:

The use of the LIFO stock valuation method provides the lowest Gross Profit figure which is advantageous during periods of inflation, however, recall that this method is not acceptable per IAS!
Stock turnover ratio
This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. The Inventory turnover ratio indicates the number of times the stock has been replaced during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not.
Components of the Ratio:
Average inventory and cost of goods sold are the two elements of this ratio. Average inventory is calculated by adding the stock in the beginning and at the end of the period and dividing it by two. In case of monthly balances of stock, all the monthly balances are added and the total is divided by the number of months for which the average is calculated.
Formula of Stock Turnover/Inventory Turnover Ratio:
The ratio is calculated by dividing the cost of goods sold by the amount of average stock at cost.

Inventory Turnover Ratio =
Cost of goods sold ÷ Average inventory at cost
Generally, the cost of goods sold may not be known from the published financial statements. In such circumstances, the inventory turnover ratio may be calculated by dividing net sales by average inventory at cost. If average inventory at cost is not known then inventory at selling price may be taken as the denominator and where the opening inventory is also not known the closing inventory figure may be taken as the average inventory.
The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost).
Calculate inventory turnover ratio
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
This means that an average one dollar invested in stock will turn into ten times in sales
Significance of ITR:
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold; the lower amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit; a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by relatively high profits. Similarly a high turnover ratio may be due to under-investment in inventories.
It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions. However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis.ii

Days Sales in Inventory Indicates the length of time that it will take to use up the inventory through sales.
Ending Inventory Cost of Goods Sold ÷ 365 This is a financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI varies from one industry to another.iii
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