Inventories refer to the closing stock of goods a company has at the end of the financial year. it includes raw materials, finished goods and work-in-progress. the company must value their inventories using the guidelines of the accounting standards. inventory is one of the most important assets of a business since inventory is one of the primary sources of revenue generation.
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Meaning of Inventories
A company always has some stock lying with them which is termed inventory. The stock can be in the form of finished goods, raw material, tools and spare parts. This stock is what we refer to as inventories.
Inventory is classified as a current asset on a company's balance sheet. It defines the resources that are usable but idle at that time and includes different type of stocks like raw material, work in progress, finished goods, tools, spare parts etc.
Inventory is an asset if it held for one of the following three purposes.
Assets held for sale in the normal course of business,
Held for production of goods,
For the consumption in the production of goods
At the end of every financial year, the company must make a schedule of its inventory, this is done to determine the value of the closing balance of the inventory. This closing balance is a very important figure in preparing the final accounts of the company, it will reflect in the asset side of the balance sheet and the credit side of the trading account.
Classification of Inventories
Inventory can be classified into two major categories Direct inventory and Indirect inventory, further direct inventory can be classified into raw material, semi-finished good (work-in-progress), finished goods.
Direct inventories:- Direct inventories include such items that can be directly used to produce or manufacture a part of the goods/services produced or provided. Direct inventories can be further classified into the following types:
Raw material:- A raw material also known as unprocessed material is a basic material that is used to produce finished products. For example, sugarcane is the raw material in a sugar factory, rubber is a raw material in a tire factory. Raw materials always kept in stock to make the production process uninterrupted.
Semi-furnished goods:- Semi-furnished goods are also known as work-in-progress. semi-finished goods awaiting completion or are in the production process. In simple words, semi-finished goods are goods that are not completed 100%. hence cannot be sold or used for consumption. For example, led housing is an incomplete product by further production it will be used to make led which is a finished product.
Finished goods:- Finished goods are goods that have completed their manufacturing process and are ready to sell to customers, but which have not yet been sold to the customer. The value of finished goods is considered as a current asset since it is expected to convert into cash by selling in less than one year, for example, petrol is finished good, whereas crude oil is raw material.
Indirect inventory:- Indirect inventories include items which are necessary for manufacturing but not become component of the finished goods. They normally include petrol, maintenance materials, office materials, grease, oil lubricant. These inventories are used for the business's ancillary purpose and cannot be assigned to a specific physical unit.
Valuation of Inventory
Inventory's valuation is the cost of goods in the inventory at the end of an accounting period. The valuation includes the cost incurred to acquire the inventory and get it ready for sale. Inventories should be valued at cost or net realizable value whichever is less for determining the value of inventory. Inventories are the largest current asset for a business. Inventory valuation allows you to evaluate your cost of good and (COGS) and profit.
Objectives of inventory's valuation
Inventory's valuation is done at the end of every financial year to calculate the cost of good sold and the unsold inventory cost.
Inventory valuation determines the gross income of a business with the help of the below formula you can calculate the cost of good sold(COGS) and gross profit. Cost of good sold = Opening stock + Purchase - Closing stock Gross profit = Sale - Cost of good sold (COGS)
The closing stock value is shown as a current asset on the balance sheet, which determines the business's financial position.
Methods of valuation of inventory
The most used method for calculation of inventories are FIFO (First-in, First-out), LIFO (Last-in, First-out) and WAC (Weighted average cost)
FIFO (First-in, First-out):- FIFO method means First-in First-out, the stock that is purchased first will be sold first. FIFO is the most common method of inventory valuation used by a business as it is simple and easily understandable. The FIFO method yields a higher value of ending inventory, resulting in higher gross profit as the stock's first item is usually cheap. Well, it also has a disadvantage too. FIFO method is easily understandable but it fails to offer any tax advantage like the LIFO method.
LIFO (Last-in, First-out):- LIFO method means last-in, first-out, the stock which is purchased last will be sold first. This method is not famous like FIFO methods as it is somewhat difficult to understand and implements. By applying the LIFO method you can decrease your inventory value, this method is rarely used because if the older inventory is not being sold its value gradually decreases and a result in the loss to the business as we discussed before everything has advantage and disadvantage, LIFO also has some advantage. By selling the new stock you can increase your cost of goods sold and result in lower profit. Which also help to pay fewer taxes.
WAC (weighted average cost):- Weighted average cost method is basically the average of total inventory. In simple words, when we calculate the price per unit by taking the average, then it is called the weighted average cost method. It can be calculated as follows:- Weighted average per unit = Total cost of goods in inventory / Total units in inventory This method is commonly used when it is difficult to track the individual cost.
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