The Importance of correct inventory valuation

We all know the importance of holding the correct inventory levels in our business, ensuring we meet customer demand, yet minimising stock holding costs and risks of obsolesce. However, do you know the impact of ensuring you have inventory recorded at the correct value?

UK Accounting Standards (FRS102) state that inventory must be held in the company records at the lower of cost and the estimated selling price less costs to complete and sell. But how do we calculate cost?

Many SME business’ value their inventory based on the most recent purchase invoice from their supplier as this is the easiest method, however, is this accurate and what about the valuation of work in progress?

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CALCULATING THE INVENTORY “COST”

Below is a summary of what should make up the calculation of “cost” for each line of inventory

Cost of purchase must include:	Further comments
Purchase price	Inventory should be recorded at the spot rate at the date of the transaction if purchased in a foreign currency.
Import duties and other taxes	These costs should be included unless recoverable from the relevant authorities.
Transport and carriage costs	These costs should be included to the extent that they are directly attributable to the purchase of inventory.
Trade discounts and rebates	Any trade discounts or rebates should be deducted from the cost amount.

Cost of conversion (work in progress) must include:	Further comments
Costs directly related to converting raw materials into finished goods	For example: – Direct labour (to include: gross wages, employers NIC, pensions, employee benefits) – Subcontractor costs – Specific components
Variable production overheads	For example: – Indirect materials (adhesives, packaging etc.) – Indirect labour (to include: gross wages, employers NIC, pensions, employee benefits)
Fixed production overheads	For example: – Depreciation of plant, equipment, factory buildings – Maintenance of plant, equipment, factory buildings – Factory management costs and administration

Once the cost has been established, there are several valuation methods permitted under UK accounting standards, which are:

• Specific Identification – this method is used for inventory items that are one-off bespoke items or produced for specific projects.
• FIFO (First items to enter the inventory are the first to be used)
• Weighted average

Depending on the valuation basis used, it is clear from the above that you may end up with differing values for stock and work in progress. The impact of this difference on the financial statements is potentially significant and we have provided a worked example below to show the difference under both the FIFO and weighted average bases of valuing inventory:

VALUING INVENTORY EXAMPLE

Best Products Limited holds 200 widgets at its year end of 31 December 2017. The company’s purchases and sales of stock in the year were as follows:

Date of transaction		Quantity of widgets	Invoice price per unit	Total cost
1/10/17	Purchase	150	£2	£300
1/11/17	Purchase	100	£2.50	£250
1/12/17	Sold	(50)	£5
31/12/17		200

Using the FIFO method of valuation, the stock would be valued at £450 at 31 December 2017 or £2.25 per unit [(150-50) x £2 + (100 x £2.50)].

Using the weighted average method, the stock would be valued at £440 at 31 December 2017 or £2.20 per unit [(150 x £2) + (100 x £2.50)x 200/250].

IMPACT ON PROFITABILITY

If we consider the impact on profitability under the two scenarios:

Year end 31/12/2017	FIFO	Average cost
Sales	250	250
Purchases	500	550
Less closing stock	(450)	(440)
Total purchases	100	110
Profit before tax	150	140
Gross profit margin	60%	56%
Tax (19%)	(29)	(27)
Profit after tax	121	113

Source: https://www.menzies.co.uk/calculating-inventory-valuation/