Additional Valuation Problems for Inventories

Unit 3:  Additional Valuation Problems For Inventories

3.1 Introduction

an attempt has been made in this unit to explain valuation of inventory valuation and the  problems such as valuation at lower of cost or market, retail method and gross profit method of estimating an inventory cost.

 

3.2 Valuation at lower of cost or market (LCM)

It was explained how costs are assigned to ending inventory and cost of goods sold using one of four costing methods (FIFO, LIFO, Weighted average, or specific identification). Yet, the cost of inventory is not necessarily the amount always reported on a balance sheet. Accounting principles require that inventory be reported at the market value of replacing inventory when market is lower than cost. Merchandise inventory is then said to be reported on the balance sheet at the lower of cost or market (LCM).

In applying LCM, cost is the acquisition price of inventory computed using one of the historical cost methods - specific identification, FIFO, LIFO, and Weighted average; market is defined as the current market value (cost) of replacing inventory. It is the current cost of purchasing the same inventory items in the usual manner. It is important to know that market is not defined as the sales prices. A decline in market cost reflects a loss of value in inventory. This is because the recorded cost of inventory is higher than the current market cost. When this occurs, a loss is recognized. This is done by recognizing the decline in merchandise inventory from recorded cost to market cost at the end of the period.

LCM is applied in one of three ways:

  1. Separately to individual item
  2. To major categories of items
  3. To the whole of inventory

The less similar the items are that make up inventory, the more likely it is that companies apply LCM to individual items. Advances in technology further encourage the individual item application.

Illustration

The following are the inventory of ABC motor sports, retailer.

Inventory            units                              per unit

   Items              on hand                     cost                 market

Cycles:

Roadster                      50                 Br. 15,000       Br. 14,000

Sprint                           20                  9,000               9,500

Off Road:

Trax-4                         10                    10,000             11,200

Blaz’m                           6                    16,000             14,500

Let us see LCM computation under the three ways:

 1. Separately to each individual item

Inventory items               Total cost                Total market                         LCM

Roadster                        Br. 750,000               Br. 700,000                     Br. 700,000

     Sprint                             180,000                     190,000                           180,000

Categories sub total      Br. 930,000               Br. 890,000

    Trax-4                              100,000                     112,000                            100,000

     Blaz’m                              96,000                       87,000                              87,000

Categories sub total      Br. 196,000               Br. 199,000                

    Totals                      Br.1,126,000               Br. 1,089,000              Br. 1,1,067,000

2.Major categories of items

Inventory                    Categories                    Categories                                LCM

categories                     total cost                     total market    

Cycles                            Br. 930,000              Br.  890,000                              Br. 890,000

Off. Road                            196,000                     199,000                                    199,000

Totals                          Br. 1,126,000              Br. 1089,000                           Br. 1,086,000

When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since this market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for inventory on the balance sheet. When LCM is applied to individual items of inventory, the marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount reported for inventory. When LCM is applied to the major categories of inventories, the market is Br. 1,086,000 which is also lower than cost.

 

3.3 Estimating inventory cost

In practice, an inventory amount is estimated for some purposes. When it is impossible to take a physical inventory or to maintain perpetual inventory records.

Example

  1. Monthly income statements are needed. It may b e too costly, to take physical inventory. This is especially the case when periodic inventory system is used.
  2. When a catastrophe such as a five has destroyed the inventory. In such case, to ask claims from insurance companies, the is a need of estimated inventory.

To estimate the cost of inventory, two methods are used. These are retail method and gross profit method.

   3.3.1 Retail method of inventory costing

This method is mostly used by retail business. The estimate is made based on the relation ship between the cost and the retail price of merchandise available for sale.

The steps to be followed are:

  1. Calculate the cost to retail ratio  =  Cost of merchandise available for sale
                                                     Retail Price of merchandise available for sale
  2. Calculate the ending inventory at retail price
      Ending inventory at retail price  =  retail price of merchandise available for sale – Sales
  3. Calculate the estimated cost of ending inventory
    Estimated cost of ending inventory  =  Cost to retail ration X Ending inventory at retail

Example

                                                                  Cost                 Retail

            Sep. 1, beginning inventory              Br. 25,000          Br. 40,000

            Purchases in September (net)           125,000            160,000

            Sales in September (net)                                         140,000

(1) Cost retail ration = Br. 25,000 + Br. 125,000   = 0.75

                                     Br. 40,000 + Br. 160,000                                                                                          

(2) Ending inventory at retail  =  (Br. 40,000 + Br. 160,000) – Br. 140,000  =  Br. 60,000

(3) Estimated ending inventory at cost  =  0.75 X Br. 60,000

                                                               =  Br. 45,000           

   3.3.2 Gross profit method

This method uses an estimate of the gross profit realized during the period to estimate the cost of inventory. The gross profit rate may be estimated based on the average of previous period’s gross profit rates.

The steps are as follows:

  1. The gross profit rate is estimated and then estimated gross profit is calculated.
     Estimated gross profit = Gross profit rate X Sales
  2. Cost of merchandise sold is estimated
      Estimated cost of merchandise sold = Sales - Estimated gross profit
  3. Calculate the estimated cost of ending inventory
      Estimated cost of ending inventory =

                Cost of merchandise available for sale – Estimated cost of merchandise sold.

Example

Oct. 1, beginning inventory (cost) –   Br. 36,000

Net purchases during October (cost)      204,000

Net sales during October                        220,000

Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

  1. Estimated gross profit = 0.4 X 220,000
                                     = Br. 88,000
  2. Estimated cost of merchandise sold
                = Br. 220,000 – Br. 88,000
                = Br. 132,000
  3. Estimated cost of ending inventory
       = (Br. 36,000 + 204,000) – Br. 132,000
       = Br. 240,000 – Br. 132,000
       = Br. 108,000

 

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