Stock valuation methods

Stock valuation methods

After determining the physical quantities of stock, the next step is assigning costs to each item to calculate the value of closing stock for inclusion in financial statements. The techniques used to determine stock value at a particular time are called stock valuation methods.

Standard stock valuation methods

Stock valuation methods provide a systematic way to assign costs to inventory quantities. According to IAS 2 (International Accounting Standard 2), the cost of each stock item should be determined through specific identification of individual costs, where each stock item is evaluated and costed individually. Alternatively, IAS 2 permits two other standard methods for stock valuation:

1. First In, First Out (FIFO) Method
2. Weighted Average Cost Method

First In, First Out (FIFO) method

In the FIFO method, it is assumed that the items received first are issued or consumed first. Consequently, the materials received last remain in stock. The closing stock is thus valued based on the most recent purchase costs. This method is rational for most businesses as it aligns with the natural flow of inventory.

Advantages of FIFO

1. Simple to understand and apply.
2. Aligns with the natural order of issuing older stock first.
3. Closing stock values closely match market prices.
4. Reduces opportunities for income manipulation.
5. Provides clear and unambiguous cost values for goods sold.

Disadvantages of FIFO

1. Inflated profits during periods of inflation, leading to higher tax liabilities.
2. Inefficiency in handling multiple purchase rates over a period.
3. Understates current production costs when material prices rise rapidly.
4. Requires multiple pricing levels under certain conditions.

To implement FIFO effectively, businesses must maintain accurate records of inventory receipts and issues. Without proper documentation, stock valuation becomes challenging.

Weighted average cost method

The weighted average cost method addresses some disadvantages of the FIFO method. Under this approach, inventory items are valued based on an average cost per unit. This average cost is calculated by dividing the total cost of purchases and opening stock by the total number of units available for sale.

Formula

$\text{Weighted Average Cost} = \frac{\text{Total Cost of Purchases} + \text{Value of Opening Stock}}{\text{Total Number of Units Available for Sale}}$

Where:

$\text{Total Number of Units Available for Sale} = \text{Opening Stock} + \text{Purchases}$

Weighted average cost is typically recalculated periodically or whenever new inventory is received.

Advantages of weighted average cost method

1. Logical and consistent in application.
2. Minimizes the impact of price fluctuations on stock valuation.
3. Simplifies the process by eliminating frequent recalculations unless new stock is acquired.

Disadvantages of weighted average cost method

1. Involves significant clerical effort.
2. Becomes cumbersome when prices change frequently.
3. The average cost may not reflect the actual price, reducing its realism.

Example

Mzee Busara deals with buying and selling of door carpets. The following transactions relate to his purchases for the year to December, 2020:

Transaction Details

Date	Units Sold	Units Purchased	Unit Cost (TZS)	Total Cost (TZS)
5th January, 2020		120	6,000	720,000
10th February, 2020	120
28th March, 2020		280	6,200	1,736,000
03rd April, 2020	160
10th April, 2020		160	6,300	1,008,000
20th May, 2020	80
30th June, 2020		240	6,400	1,536,000
10th July, 2020	200
4th August, 2020	100
28th August, 2020		400	6,600	2,640,000
02nd September, 2020	220
10th November, 2020		100	6,800	680,000
20th December, 2020	280
Total	1,160	1,300		8,320,000

Stock in hand at 31st December, 2020 was 140 units (1,300 – 1,160). Total sales for the year were TZS 9,000,000.

Required:

Calculate the value of closing stock and cost of sales using FIFO and weighted average cost under periodic inventory system.

Solution

FIFO method under periodic stock-taking system:

Under this method, the closing stock of 140 units will be made up of the most recent units to enter the store (recent purchases). So, the 100 units will be based on 10th November purchases and the balance 40 units will relate to 28th August, 2020 purchases. The value of closing inventory of 140 units is calculated as follows:

FIFO method

Month	Units	Unit Costs (TZS)	Total Costs (TZS)
November	100	6,800	680,000
August	40	6,600	264,000
Total	140		944,000

Cost of goods sold (FIFO method)

Description	Amount (TZS)
Total Purchases	8,320,000
Less: Closing Stock	(944,000)
Cost of Sales	7,376,000

Weighted average cost method

Formula: Weighted Average Cost = (Total Cost of Purchases + Value of Opening Stock) ÷ Total Number of Units Available for Sale

Weighted Average Cost = (8,320,000 + 0) ÷ 1,300 = TZS 6,400 per unit

Value of closing stock (weighted average method)

Value of Closing Stock = 140 units × TZS 6,400 per unit = TZS 896,000

Cost of goods sold (weighted average method)

Description	Amount (TZS)
Total Purchases	8,320,000
Less: Closing Stock	(896,000)
Cost of Sales	7,424,000