Inventories may be:
raw materials or components bought from suppliers
finished goods which have been made by the business but not yet sold
part completed items
goods purchased and held for resale
Definition
Cost of inventories: All costs of purchase, of conversion (eg, labour) and of other costs incurred in bringing the items to their present location and condition.
Cost of purchase: The purchase price, import duties and other non-recoverable taxes, transport, handling and other costs directly attributable to the acquisition of finished goods and materials.
6.3.1 What is included in the total cost of an item of inventory?
The total cost of an item of inventory includes all costs incurred in bringing the item to its present location and condition. This consists of:
the purchase cost of raw materials
delivery inwards
import taxes and duties
conversion costs
C H A P T E R 7
Definition
Conversion costs: Any costs involved in converting raw materials into final product, including labour, expenses directly related to the product and an appropriate share of production overheads (but not sales, administrative or general overheads).
Worked example: Cost of manufactured goods
A business has the following details relating to production and sales for a reporting period:
Sales: 900 units at £600 each
1,000 units are produced with the following costs being incurred:
Opening inventory of raw materials: 200 units at £100 each Purchases of raw materials: 1,050 units at £100 each Closing inventory of raw materials: 250 units at £100 each
Production wages £150,000
Production overheads £100,000
General administration, selling and distribution costs £100,000 The cost of production should include an appropriate share of production wages and
production overheads, but not non-production expenses.
The statement of profit or loss of this business for the reporting period is as follows:
£ £
Sales (900 units £600) 540,000
Cost of production (1,000 units) Inventories
Opening inventory (200 £100) 20,000
Purchases (1,050 £100) 105,000
Less closing inventory (250 £100) (25,000)
Cost of raw materials used 100,000
Production wages 150,000
Production overheads 100,000
Cost of production (1,000 units cost £350,000/1,000 = £350 each) 350,000 Less closing inventory, finished goods (100 £350) (35,000)
Cost of sales (315,000)
Gross profit 225,000
General administration, selling and distribution costs (100,000)
Net profit 125,000
The cost of production is spread over the units produced. Any unsold units are valued at a figure that reflects a share of these costs. When the inventory is eventually sold, the production
overheads associated with its manufacture will be thereby properly matched with the revenues earned.
6.3.2 What is the total cost of items left in inventory?
A business may be continually adding items to finished goods inventory, or purchasing a particular component. As each consignment is received from suppliers, or each finished goods batch is added to inventory, they are stored in the appropriate place, where they will be mingled with items already there. These goods are considered interchangeable in that the storekeeper would not distinguish between items when they issue items to production or to despatch. They will simply pull out the nearest item to hand, which may have arrived in the latest
consignment/batch, in an earlier consignment/batch or in several different consignments/batches.
There are several techniques which are used in practice to attribute a cost to interchangeable inventory items; remember that actual materials, components and finished goods items can be issued in any order irrespective of when each one entered inventory.
Definitions
FIFO (first in, first out): Items are assumed to be used in the order in which they are received from suppliers, so oldest items are issued first. Inventory remaining is therefore the newer items and cost is measured as such.
LIFO (last in, first out): Items issued are assumed to be part of the most recent delivery, while oldest consignments are assumed to remain in the stores. LIFO is not allowed under IFRS.
AVCO (average cost): As purchase prices can change with each new consignment received, the average value of an item is constantly changing. Each item at any moment is assumed to have been purchased at the average price of all the items together, so inventory remaining is therefore valued at the most recent average price.
In the exam you can expect to use FIFO or AVCO for the valuation of inventory in the statement of financial position and the statement of profit or loss.
Worked example: FIFO and AVCO
To illustrate the FIFO and AVCO methods of valuing inventory, the following transactions will be used.
Transactions during May 20X7
Quantity Unit cost Total cost
Units £ £
Opening balance 1 May 100 2.00 200
Receipts 3 May * 400 2.10 840
Issues 4 May ** 200
Receipts 9 May 300 2.12 636
Issues 11 May 400
Receipts 18 May 100 2.40 240
Issues 20 May 100
Closing balance 31 May 200
1,916
* Receipts mean goods are received into store.
** Issues represent the issue of goods from store.
The problem is to put a valuation on the following:
(a) The issues of goods (b) The closing inventory Requirement
How would issues of goods and closing inventory be valued using:
(a) FIFO?
(b) AVCO?
Solution
(a) FIFO assumes that goods are issued out of inventory in the order in which they were delivered into inventory, ie, the cost of issues is deemed to be at the cost of the earliest delivery remaining in inventory.
C H A P T E R 7
The cost of issues and of closing inventory using FIFO would be as follows:
Date Quantity Issued Cost of issues
Units £ £
4 May 200 100 at £2.00 200
100 at £2.10 210
200 410
11 May 400 300 at £2.10 630
100 at £2.12 212
400 842
20 May 100 100 at £2.12 212
1,464
Closing inventory 200 100 at £2.12 212
100 at £2.40 240
200 452
1,916 Note that the cost of goods issued plus the cost of the closing inventory equals the cost of purchases plus the cost of opening inventory (£1,916).
(b) AVCO may be used in various ways in costing inventory issues. The most common is the cumulative weighted average pricing method illustrated below.
A weighted average cost for all units in inventory is calculated. Issues are valued at this average cost, and the balance of inventory remaining has the same unit cost.
A new weighted average cost is calculated whenever a new delivery of goods into store is received.
Date Received Issued
Balance
Total inventory
value
Unit cost
Cost of issue Units Units Units £ £ £
Opening inventory 100 200 2.00
3 May 400 840 2.10
500 1,040 2.08 *
4 May 200 (416) 2.08 ** 416
300 624 2.08
9 May 300 636 2.12
600 1,260 2.10 *
11 May 400 (840) 2.10 ** 840
200 420 2.10
18 May 100 240 2.40
300 660 2.20 *
20 May 100 (220) 2.20 ** 220
1,476 Closing inventory
value 200 440 2.20 440
1,916
* A new unit cost is calculated whenever a new receipt of goods occurs.
** Whenever goods are issued, the unit value of the items issued is the current weighted average cost per unit at the time of the issue.
For this method too, the cost of goods issued plus the cost of closing inventory equals the cost of purchases plus the cost of opening inventory (£1,916).