Valuation of inventory is very important both in the context of financial reporting as well as management reporting, as it affects both the income statement (cost of goods sold) and the balance sheet (assets).
Fundamental rule for valuation of inventory is the same as given in IAS-2. Inventory must be valued at lower of the following:
- Net realizable value (NRV)
Net realizable value (NRV)
As the name suggests, it is the amount that can be realized by disposing or selling the inventory after taking into account any additional cost required to make the inventory saleable.
NRV = Expected selling price – expected cost to make the item ready for sale
Cost is simply the purchase price paid/ payable for the inventory item plus any additional costs such as carriage, conversion cost etc incurred to bring the item in its present condition and location.
Where inventory consists of small number of large or precious items, it is possible to identify individual items of inventory and their actual costs. However, in most of the cases, it is not possible. Usually inventory consists of large number of items and keeping track of actual costs of each item is virtually impossible.
Questions arise like what should be the cost of inventory issued? What amount should be taken to cost of goods sold? One of the following inventory valuation techniques can be used to answer such questions:
- First-in, First-out method (FIFO)
- Weighted average cost method (AVCO)
- Last-in, First-out method (LIFO)