Explanation of Inventory Cost

By | January 7, 2022

The meaning of inventory cost

Inventory means goods- be it finished products or raw materials / raw materials, for sale, or for personal use by the business entity at a time.

Inventory consists of three elements – raw materials to be used in the production process, goods in process or incomplete goods in the production process, and finally, finished products – either for sale or for personal consumption by the business entity.

Inventory is a current asset for the body and is assumed to be converted into money for the company’s income.

And inventory costing is the process of assigning a monetary value to the inventory in the hands of a business entity (company) at any point in time.

The importance of inventory costs

Correct costing of inventory is very important for any business as it affects COGS ( Cost of Goods Sold ) directly.

The costs, in turn, will affect the entity’s gross profit and, ultimately, its taxable income. Therefore, the determination of inventory costs is very important and will directly affect the preparation of all important financial statements of an entity, which can be in the form of income statements  and  balance sheets .

Different inventory costing methods can provide different inventory values ​​on hand. If a technique places a high value on inventory, the cost of goods sold will fall.

Gross profit will increase, and accordingly, taxable income will also increase. On the other hand, if a method sets a lower inventory value, the cost of goods sold will increase. Gross profit will decrease, and accordingly, taxable income will also decrease.

Inventory costing method

There are four important methods for inventory costing.

Special identification method

The cost of each inventory component is tracked explicitly in this method. Cost of goods sold and closing stock are calculated after that.

Because this method is very complicated, it can only be used with large items such as cars or items that are unique and of high value. In most cases, it is difficult to assign costs to each component of the inventory. Therefore, this method is not preferred.

Metode First in First Out

In this method the assumption is that the goods purchased first will be consumed first. This method is the most logical and rational of all.

This is because inventory is used this way only in most organizations. This also means that the items remaining in the inventory are the most recently purchased items.

The closing stock will be worth more when the price rises. This means that the Cost of Goods Sold will be lower. Therefore, the gross profit will be higher, and so will the taxable income under this method.

Metode Last in First Out

This method is the opposite of FIFO. The assumption is that the items in the entity’s last purchased inventory will be used first.

Thus, the items in the closing inventory will be the items purchased at the beginning. This is contrary to the general policy of consuming goods. Therefore, this method is not preferred for inventory costing.

When the price goes up, the item that the entity bought at the higher price will be used first. This means that the Cost of Goods Sold will increase.

Gross profit will decrease, as will taxable income. Items in closing stock are valued at the older lower rate. Therefore the value will be lower.

Weighted average method

Inventory values ​​are constantly changing with this method. The weighted average rate is calculated at the time of purchase of new goods. Cost of Goods Sold, gross profit, and closing stock value are calculated by this average cost.

An example of calculating inventory costs

Let us assume that PT ABCDEFGH. producing biscuits.

The first inventory is 3000 units @ US$2 per unit.

Production for the next three months is 2000 units per month.

And input costs increase.

The results are worth $2.25, $2.5, and $2.75 per unit for three months, respectively.

Sales for the period were 7000 units, and the final stock available was 2000 units. The selling price for each unit is US$4.

Sales- 7000 units x 4= US$28000.

Total production- 2000 units x 2.25 + 2000 units x 2.5 + 2000 units x 2.75 = US $ 15000.

If we use the Specific Identification method  , it is almost impossible to calculate costs and allocate them correctly because input costs are constantly increasing.

Let’s see how the numbers work under  FIFO  . The first unit on hand is the first to be sold.

Therefore, Cost of Goods Sold- (3000 units x 2 + 2000 units x2.25 + 2000 units x2.5) = US$15500.

Closing Stock- 2000 units x 2.75= US$5500.

Gross profit- $ 28000- $ 15500 = US $ 12500

In the case of  LIFO  –

The last units produced will be sold first. The  1  2  units from the start will be closing stock .

Selling Price- (2000 units x 2.75 +2000 units x 2.5 +2000 units x 2.25 +1000 units x 2) = US $ 17000

Closing Stock- 2000 units x 2= US$4000

Gross Profit- $ 28000- $ 17000 = US $ 11000

Weighted Average Method

In this method, we will take a weighted average of all units and their prices. Then the weighted average cost is taken to calculate Cost of Goods Sold and closing stock.

Weighted Average- (3000 units x 2 + 2000 units x 2.25 +2000 units x 2.5 + 2000 units x 2.75) / 9000 units= 21000/9000= $2.33 per unit

Cost of Goods Sold- 7000 units x 2.33= US$ 16330

Closing Stock- 2000 units x 2.33= US$4670

Gross Profit- $ 28000- $ 16310 = US $ 11690.

Inventory Cost Interpretation

From the above example, we can interpret as follows:

  1. If input prices are constant, all three methods will give the same Cost of Goods Sold and closing stock.
  2. During an inflationary trend in the economy, that is, with prices continuing to rise, Cost of Goods Sold will be lowest under FIFO and highest under LIFO. It would be somewhere in between the two under the weighted average method.
  3. As such, the closing stock will be highest under FIFO, lowest under LIFO, and somewhere in between under the weighted average method.
  4. Inventory costing affects the gross profit and, accordingly, the taxable income and taxes that the company has to pay. In the example above, gross profit and tax would be highest under FIFO, middle under the weighted average method and lowest under LIFO.
  5. During a deflationary trend in the economy, i.e. with prices continuing to decline, all of the above parameters will be the other way around.
  6. Management needs to identify which methods are appropriate for their organization. The method chosen must be disclosed at the time of preparation of the final account. Inventory is part of the current assets of a company. Therefore, the valuation figures will also have an impact on various financial ratios obtained using current assets.
  7. Management should wisely choose the inventory costing method as it also affects profit, revenue and taxation figures. These figures will be important to stakeholders such as investors and regulatory authorities. Moreover, they will be relevant to the management itself for decision making.