Unit 3: Additional Valuation Problems For Inventories
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:
- Separately to individual item
- To major categories of items
- 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.
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Items on hand cost market
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
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.
- 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.
- 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:
- Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
- Calculate the ending inventory at retail price
Ending inventory at retail price = retail price of merchandise available for sale – Sales
- Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = Cost to retail ration X Ending inventory at 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:
- The gross profit rate is estimated and then estimated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales
- Cost of merchandise sold is estimated
Estimated cost of merchandise sold = Sales - Estimated gross profit
- Calculate the estimated cost of ending inventory
Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold.
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:
- Estimated gross profit = 0.4 X 220,000
= Br. 88,000
- Estimated cost of merchandise sold
= Br. 220,000 – Br. 88,000
= Br. 132,000
- Estimated cost of ending inventory
= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000