IAS 2 classifies inventory into three distinct categories:

1. Raw Materials — These are inputs or factors of production required in the manufacturing process. They can be:

• Direct materials: Used in the manufacturing process and become part of the final product (e.g., timber in carpentry, cotton in textiles)
• Indirect materials: Do not form part of finished goods but are consumed during production (e.g., oil for lubricating machines)

2. Work in Progress — Items midway through the production process; unfinished or partly complete at the end of the accounting period (e.g., a partly complete building, an undecorated cake)

3. Finished Goods — The output of the production process; the end result available for sale (e.g., a completed table, a decorated cake)

Periodic System

In this system, inventory-taking and valuation are conducted after a set period (monthly, quarterly, or annually). Physical counting of goods determines the ending inventory. Suitable for businesses with wide variety of goods and low unit costs (e.g., supermarkets, hardware stores).

Perpetual System

This involves continuous inventory-taking and valuation after every transaction. All inventory movements are recorded in the inventory ledger, providing ongoing information about cost of sales and remaining inventory. Suitable for businesses with fewer sales of high-value items (e.g., motor vehicles, furniture).

After quantifying physical inventory, costs are assigned to each item. The three main valuation methods are:

First In First Out (FIFO)

Assumes that items received first are issued or sold first. Ending inventory consists of the most recent purchases, valued at current prices.

Advantages:

• Easy to understand and use
• Consistent with normal flow of goods
• Closing inventory value close to market price
• Makes manipulation of reported income difficult

Disadvantages:

• Overstates profits during inflation (may attract higher taxes)
• Does not work effectively if many units purchased at different rates
• Understates current production costs when prices are rising

Last In First Out (LIFO)

Assumes that the most recent items acquired are sold first. Ending inventory is valued at earliest cost prices.

Advantages:

• Tax efficiency during inflationary periods (lower reported profits)
• Better matching of current costs with revenues

Disadvantages:

• Lower reported profits may discourage investors
• Older inventory items may stay on hand, becoming outdated
• Risk of LIFO liquidation

Note: IAS 2 does not permit the use of LIFO method in financial reporting. In Tanzania, businesses following IFRS should not use LIFO.

Weighted Average Cost Method (WAM)

Inventory is valued at the average price of purchases, weighted by quantity purchased at each price.

$\text{Weighted Average Cost} = \frac{\text{Total cost of purchases} + \text{Value of opening inventory}}{\text{Total units available for sale}}$

Advantages:

• Consistent and logical
• Price fluctuations have minimal effect on issue costs
• Simpler than tracking individual units

Disadvantages:

• Involves considerable clerical work
• Complex when prices change frequently
• Average cost is not the actual price

Example: Mzee Busara had the following purchases of door carpets during 2023:

Total units sold: 1,160 Closing inventory: 140 units

Solution

FIFO Method: Closing inventory consists of most recent purchases:

• 100 units × TZS 6,800 = TZS 680,000
• 40 units × TZS 6,600 = TZS 264,000
• Total closing inventory: TZS 944,000

Cost of sales = Total purchases − Closing inventory = TZS 8,320,000 − TZS 944,000 = TZS 7,376,000

LIFO Method: Closing inventory consists of oldest purchases:

• 20 units × TZS 6,000 = TZS 120,000
• 120 units × TZS 6,200 = TZS 744,000
• Total closing inventory: TZS 864,000

Cost of sales = TZS 8,320,000 − TZS 864,000 = TZS 7,456,000

WAM Method: $\text{Weighted Average Cost} = \frac{8,320,000}{1,300} = \text{TZS 6,400 per unit}$

Closing inventory = 140 × TZS 6,400 = TZS 896,000 Cost of sales = TZS 8,320,000 − TZS 896,000 = TZS 7,424,000

During rising prices:

• FIFO: Higher closing inventory → Lower COGS → Higher profit
• LIFO: Lower closing inventory → Higher COGS → Lower profit
• WAM: Results fall between FIFO and LIFO

The choice of method affects reported profit, tax liabilities, and the statement of financial position.

According to IAS 2 and the prudence concept, inventory should be reported at the lower of cost or net realisable value.

• Cost: Purchase cost plus incidental costs
• Net Realisable Value (NRV): Estimated selling price less estimated costs to make the sale

Example: 10 pairs of shoes purchased at TZS 18,000 each (total TZS 180,000). Damaged shoes require TZS 1,000 per pair repairs, then sold for TZS 17,500 each.

• Cost = TZS 180,000
• NRV = (TZS 17,500 × 10) − (TZS 1,000 × 10) = TZS 175,000 − TZS 10,000 = TZS 165,000

Inventory should be valued at TZS 165,000 (lower of cost or NRV).

When physical inventory-taking is impractical, estimation methods are used:

Gross Profit Method

Uses the gross profit rate to estimate closing inventory:

$Margin = \frac{\text{Gross Profit}}{\text{Sales}} \times 100$

$Mark-up = \frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100$

Formula: Closing Inventory = Cost of goods available for sale − Cost of sales

Retail Method

Used by businesses with large volumes of low-priced items (e.g., supermarkets):

$\text{Cost to Retail Ratio} = \frac{\text{Cost of goods available at cost}}{\text{Cost of goods available at retail}} \times 100$

Closing inventory at cost = Cost to retail ratio × Closing inventory at retail price

Insurance is an agreement where the insurer compensates the insured for loss in exchange for a premium. The amount insured is the sum insured.

Key Concepts

Over-Insurance: Sum insured exceeds actual value. Claim equals actual loss.

Under-Insurance: Sum insured is less than actual value. The average clause applies:

$Insurance\ Claim = \frac{\text{Sum Insured}}{\text{Inventory Value at Date of Accident}} \times \text{Actual Loss}$

If there is no average clause, the claim is the lower of actual loss and sum insured.

Example: Juma's inventory was destroyed by fire on 31st December 2023. Information from books:

• Opening inventory (1st October 2023): TZS 3,600,000 (recorded at 10% less than cost)
• Purchases (Oct−Dec 2023): TZS 8,500,000 (includes plant purchase of TZS 500,000)
• Sales (Oct−Dec 2023): TZS 11,800,000
• Gross profit rate: 33⅓% on cost
• Salvaged inventory: TZS 300,000
• Sum insured: TZS 2,500,000 (subject to average clause)

Solution

Step 1: Find actual inventory value at date of accident

Opening inventory at cost = TZS 3,600,000 ÷ 0.9 = TZS 4,000,000

Cost of goods available = TZS 4,000,000 + (TZS 8,500,000 − TZS 500,000) = TZS 12,000,000

Convert mark-up to margin: $33\frac{1}{3}\% = \frac{1}{3}$

$Margin = \frac{33\frac{1}{3}}{100 + 33\frac{1}{3}} \times 100 = 25\%$

Gross profit = 25% × TZS 11,800,000 = TZS 2,950,000

Cost of sales = TZS 11,800,000 − TZS 2,950,000 = TZS 8,850,000

Closing inventory = TZS 12,000,000 − TZS 8,850,000 = TZS 3,150,000

Step 2: Calculate loss

Inventory loss = TZS 3,150,000 − TZS 300,000 = TZS 2,850,000

Step 3: Calculate insurance claim (average clause applies)

$Claim = \frac{2,500,000}{3,150,000} \times 2,850,000 = \textbf{TZS 2,261,905}$

A Tanzanian small business owner running a duka in Dar es Salaam can apply inventory accounting to determine the actual profit from selling household items. For instance, when stocking cooking oil, rice, and soap, using FIFO helps track which batches were sold first, enabling accurate profit calculation for tax purposes. If fire damages the shop, understanding insurance claims ensures the owner receives proper compensation based on the value of destroyed stock rather than the insured amount alone.