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  Costing Inventories

Introduction to Costing Inventories

The way in which we compute the cost of inventories (or stock) is significant since the cost of inventories sold throughout a period will influence the calculation of profit and the remaining inventories held at the end of the period will influence the portrayal of wealth in the statement of financial position. In the earlier chapter, we saw that historic cost is frequently the basis for reporting assets. So, it is tempting to think that ascertaining the cost of inventories held or employed is very simple. Though, in a period of changing prices, the costing of inventories can be a difficulty.

A business must ascertain the cost of the inventories sold throughout the period and the cost of the inventories remaining at the end of the period. For doing this, some assumption must be made about the way where the inventories are handled physically. The assumption made require not contain anything to do along with how the inventories are really handled. The assumption is referred only with giving helpful accounting information.

Three assumptions used are:

1 first in, first out (FIFO) - the initial inventories held are the first to be employed;

2 last in, first out (LIFO) - the latest inventories held are the first to be employed;

3 weighted average cost (AVCO) - inventories entering the business lose their separate identity and go into a 'pool'. Some issues of inventories then imitate the average cost of the inventories that are held.

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Diagram: FIFO and LIFO treatment of the inventories

Inventories - some further issues

As described earlier that the convention of prudence needs that inventories be valued at the lower of cost and net realisable value. (The net realisable value of inventories is the estimated selling price less any further costs which may be essential to complete the goods and any costs included in selling and distributing the goods.) The meaning of this rule may that the valuation method applied to inventories (cost or net realisable value) could change each year, relies on which of cost and net realisable value is the lower. Though, in practice the cost of the inventories held is generally below the current net realisable value - specifically throughout a period of rising prices. So, it is the cost figure that will generally appear in the statement of financial position.

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