LO1&2: Inventory ValuationMethods

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24/02/20201LO1&2: Inventory ValuationMethodsDr Fidelis AkangaLearning outcomesBy the end of this unit Explain process Costing Calculate & explain the treatment of normaland abnormal losses Distinguish between first in, first out (FIFO),last in, last out (LIFO), and average costmethods of stores pricing24/02/20202Process Costing Costing method used company is involved in massproduction through a sequence of severalprocesses. Cost is allocated to all processes and cost of finishedgood is valued at average unit cost of production Examples are food production, flour, chemicals It computes the cost per unit by dividing the totalcosts incurred for a particular period by the numberof units produced (output) during the periodProcess Costing Job costing assigns costs to each individualunit of output because each unit consumesdifferent quantities of resources. Process costing does not assign costs toeach unit of output because each unit isidentical. Instead, average unit costs arecomputed.24/02/20203A comparison of process and jobcostingA comparison of process and jobcosting24/02/20204Process Costing: Terminology Normal loss: This is expected wastage under normal operatingconditions such as testing and evaporation. Abnormal loss: Loss above the normal expected losses. Thismight result from faulty machinery or human/staff error Abnormal gain: This occurs when actual loss is lower thannormal expected loss. This can be a result of greater efficiencyof machinery and staffProcess Costing: Terminology Scrap Value: Outcome of a loss (damaged goods)sold for a fee Revenue arising from the sale of scrap is treated asa reduction in cost rather than an increase in salesrevenue Work in progress (WIP): These are units not yetcompleted at the end of production period24/02/20205Normal & Abnormal losses Normal losses cannot be avoided– Cost is absorbed by good production. Abnormal losses are avoidable– Cost is recorded separately– Treated as a period cost– Removed from process costs, recordedseparately as a loss in the abnormal lossaccount– Not carried forward as a future expenseExample 1In case 1: During the month the company input into theproduction process is 12 000 litres at a cost of £120000. Normal loss is estimated to be 1/6 of the input.Actual output is 9,000litres.There was no opening or closing inventories and alloutput was fully completed. Calculate cost of completeproduction and cost of abnormal loss24/02/20206Example 1 Contd
 Input£120,000 Normal loss Actual output CPU
= 12,000 litres at a cost of
= 1/6 of input= 9,000 litres= £120,000/Expected output
(10,000 litres) = £ 12
 Cost of completed production= £108,000 (9,000 ×£12)
 Cost of abnormal loss
= £12,000 (1,000 × £12)
Input CostExpected outputExample 1 Contd Workings: Expected output: 12,000 – (1/6*12,000) = 10,000litres Abnormal loss = 10,000 – 9,000 = 1,000 litres24/02/20207Inventory/(stock) Valuationmethods When stock is received into stores at different prices,a consistent system is needed in order to value thestock and issues. Material Cost = Quantity used x Price/unit Three Valuation methods: First in First Out (FIFO) Last in First Out (LIFO). Weighted Average Cost (AVCO)Inventory/(stock) ValuationmethodsFirst in First Out (FIFO)Assumes that materials are issued out of stock in theorder in which they are deliveredExample
Quantity
Unit Cost
Opening Bal 1st August

Receipt
1st August
200
50p
Receipt
5th August
100
54p
Issue
6th August
50
?
Material costs of issue under FIFO 50 units x 50p=£25.24/02/20208First in First Out (FIFO)
Date
Receipt
Issue
Stock (Balance)
Q
P
V
Q
P
V
Q
P
V
01/08



01/08



05/08



06/08



200
0.50
100
200
0.50
100
100
0.54
54
200
0.500.54
154
50
150
0.50
25
129
100
100
0.540.50First in First Out (FIFO)Advantages• It is easy to understand• The inventory valuation can be near to avaluation based on replacement cost• It is a logical pricing method, which probablyrepresents what is physically happening24/02/20209Inventory/(stock) ValuationmethodsLast in First Out (LIFO)Assumes that materials are issued out of stock inreverse order to which they were delivered.Example
Quantity
Unit Cost
Opening Bal 1st August

Receipt
1st August
200
50p
Receipt
5th August
100
54p
Issue
6th August
50
?
Material costs under LIFO 50 units x 54p =£27.Last in First Out (LIFO)
Date
Receipt
Issue
Stock (Balance)
Q
P
V
Q
P
V
Q
P
V
01/08



01/08



05/08



06/08



200
0.50
100
200
0.50
100
100
0.54
54
200
0.50
154
50
0.54
27
127
200
100
0.54
50
0.500.54
24/02/202010Last in First Out (LIFO)Advantages• Inventories are issued at a price which is close to currentmarket value.• Managers are continually aware of recent costs whenmaking decisions, because the costs being charged totheir departments or products will be current costs.Disadvantages• LIFO is often the opposite of what is physically happeningand can therefore be difficult to explain to managers.Inventory/(stock) ValuationmethodsWeighted Average Cost (AVCO)All stocks and issues are valued at an average price.The average price is recalculated after every receipt.Running Total Of CostsRunning Total Of UnitsExample: Value of issue under AVCO(200x50p)+(100x54p)200 +100= 51.333pMaterial costs of issue = 50 x 51.33p = £25.6724/02/202011Weighted Average Cost
Date
Receipt
Issue
Stock (Balance)
Q
P
V
Q
P
V
Q
P
V
01/08



01/08



05/08



06/08



200
0.50
100
200
0.50
100
100
0.54
54
300
154
50
26
250
128
0.5133
0.5133
0.5133
Weighted Average CostAdvantages• It is easier to use than FIFO and LIFO because there is no needto identify each batch separately.• Fluctuations in prices are smoothed out, making it easier to usethe data for decision makingDisadvantages• Prices tend to lag a little behind current market values when thereis general inflation24/02/202012Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 10.

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