Most common methods of valuation of inventory are mentioned below:
Methods
(a) Fifo (first in first out):
Under this method it is assumed that the units acquired first issued first. Consequently the inventory is supposed to consist of goods purchased most recently.
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(b) Lifo (last in first out):
This method considers that the units acquired last are issued first. Consequently the inventory is thought to consist of goods purchased the earliest.
(c) Weighted average:
This method takes for granted that the goods purchased are so intermingled that specific identification is not possible.
In this way the cost of one unit cannot be distinguished from the cost of another. Hence units are issued at a cost that is an average of the cost of each purchase weighted by the quantity purchased at that cost.
Consequently the closing stock is also valued at an average cost. The following illustration will make the differences clear:
500 kilograms of material was bought by a factory at different times and prices as given below :
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Purchased on October 10 – 100 kg @ Rs. 3.25
Purchased on November 8 – 250 kg @ Rs. 3.50
Purchased on December 6 – 150 kg @ Rs. 3.75
On November 22nd 250 kg of material was issued to the Production Department. Under FIFO method, the material issued will be valued at Rs. 850 (100 kg @ Rs. 3.25 and 150 kg @ Rs. 3.50 and the stock will be valued at Rs. 912.50 (100 kg @ Rs. 3.50 and 150 kg. @ Rs. 3.75).
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Under weighted average, the material issued will be valued at Rs. 881.25 and the stock will also be valued at Rs. 881.25.
Under LIFO the materials issued will be valued at Rs. 912.50 and the stock will be valued at Rs. 850.00.
In this way, it will be noticed that the value of the stock is different under different methods. Consequently, the profit figure would also be different in each method because the figure of closing stock appears at the credit of trading account.
The direction of the impact of the method adopted on the profit would depend upon the movement of prices.
In an inflationary condition the LIFO method would generally tend to produce lower income than FIFO method or Average Cost method.
The reason for this is that under LIFO method, the most recent costs, which in times of inflation are normally the higher costs, are taken into account for determining the profit.
The inventory is valued at the earliest i.e., lower cost under FIFO, these lower costs would be debited to the profit and loss account; the resultant profit will therefore, be higher.
The inventory will be valued at the higher i.e. later costs. This also will lead to higher profits. The average cost method lies somewhere in between LIFO and FIFO.
In deflation the results are just the opposite. LIFO will tend to produce higher income figures than FIFO or Average cost method.
Theoretically, deflation is as much a possibility as inflation is. But our first experience, specially after the World War II, depicts that businessmen are generally expecting the prices to go up rather than go down. In this way they have found it expedient to adopt the LIFO system.
As LIFO tends to show lower profits in inflationary periods, it tends to reduce income tax liability as well.
The tax saving advantage of LIFO method is not fully free from risks. In such cases, inflationary tendencies give way to deflation; the companies may well find that they would be better off by adopting the FIFO method. However, this may not be allowed by the income-tax authorities.
The income-tax authorities require that once a particular method of valuation is taken into account the same method must be followed consistently over the years. A change can be permitted only with the permission of the income-tax officer.
As regards the propriety of adopting the LIFO method, Joel Dean has recommended the adoption of this method.
The accounting bodies in U.K. also recommended it. But it is not permitted in Canada and Australia.