CIMA - C1 Fundamentals of Management Accounting
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
4.1 Example: AVCO
In our example, issue costs and closing inventory values would be as follows.
Total
Date
Received
Issued
Balance
inventory value
Unit cost
Units
Units
Units
$
$
$
Opening inventory
100
200
2.00
3 May
400
840
2.10
* 500
1,040
2.08
4 May
200
(416
)
2.08
416
300
624
2.08
9 May
300
636
2.12
* 600
1,260
2.10
11 May
400
(840
)
2.10
840
200
420
2.10
18 May
100
240
2.40
* 300
660
2.20
20 May
100
(220
)
2.20
220
1,476
Closing inventory value
200
440
2.20
440
1,916
* A new inventory value per unit is calculated whenever a new receipt of materials occurs.
Notes
(a) The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the value of
opening inventory ($1,916).
(b) In a period of inflation, using the cumulative weighted average pricing system, the value of material issues will
rise gradually, but will tend to lag a little behind the current market value at the date of issue. Closing inventory
values will also be a little below current market value.
4.2 Advantages and disadvantages of AVCO
Advantages Disadvantages
Fluctuations in prices are smoothed out, making it easier
to use the data for decision making.
The resulting issue price is rarely an actual price that
has been paid, and can run to several decimal places.
It is easier to administer than FIFO and LIFO, because
there is no need to identify each batch separately.
Prices tend to lag a little behind current market values
when there is gradual inflation.
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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Question
Inventory valuation methods
Shown below is an extract from records for inventory code no 988988.
Receipts Issues Balance
Date Qty Value Total Qty Value Total Qty Value Total
$ $ $ $ $ $
5 June 30 2.50 75
8 June 20 3.00 60
10 June 10 A
14 June 20 B
18 June 40 2.40 96
20 June 6 C D
(a) The values that would be entered on the stores ledger card for A, B, C and D in a cumulative weighted average
pricing system would be:
A $
C $
B $
D $
(b) The values that would be entered on the stores ledger card for A, B, C and D in a LIFO system would be:
A $
C $
B $
D $
Answer
(a) A $
27
C $
15
B $
54
D $
135
Workings
$
8 June
Inventory balance
30
units @ $2.50
75
20
units @ $3.00
60
50
135
Weighted average price = $135/50 = $2.70
10 June
Issues
10
units × $2.70
$27
14 June
Issues
20
units × $2.70
$54
18 June
Inventory balance
20
units @ $2.70
54
Remaining receipts
40
units @ $2.40
96
60
150
Weighted average price = $150/60 = = $2.50
20 June
Issues
6
units × $2.50
$15
Inventory balance
54
units × $2.50
$135
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
(b) A $
30
C $
14.40
B $
55
D $
1
3
1.
60
Workings
10 June
10
units × $3.00
$30
14 June
Remaining
10
units × $3.00
$30
10
units × $2.50
$25
$55
20 June
Issues:
6
units × $2.40
$14.40
Balance:
34
units × $2.40
81.60
20
units × $2.50
50.00
54
131.60
4.3 Periodic weighted average
The periodic weighted average pricing method calculates an average price at the end of the period, based on the total
purchases in that period.
Periodic weighted average =
Cost of opening inventory + total cost of receipts
Units of opening inventory + total units received
4.3.1 Example: Periodic weighted average
A wholesaler had the following receipts and issues during May.
Receipts units
Issues units
$/unit
4 May
800
30
6 May
400
13 May
600
35
14 May
400
23 May
600
40
25 May
400
29 May
400
2,000
1,600
Calculate the value of closing inventory at the end of May using the periodic weighted average.
Periodic weighted average =
(800 x $30) + (600 x $35) + (600 x $40)
800 + 600 + 600
= $34.50 per unit
Value of closing inventory = 400 units x $34.50
= $13,800
As this method is easier than the cumulative weighted average method you are less likely to get a question on it in the
assessment! Make sure you use the cumulative weighted average method unless the assessment question specifically
mentions the periodic weighted average .
Assessment
focus point
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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5 Inventory valuation and profitability
Each method of inventory valuation (usually) produces different figures for both the value of closing inventories and also
the cost of material issues. Since materials costs affect the cost of production, and the cost of production works through
eventually into the cost of sales (which is also affected by the value of closing inventories), it follows that different
methods of inventory valuation will provide different profit figures.
The following example will help to illustrate the point.
5.1 Example: inventory valuation and profitability
On 1 November 20X2, Delilah's Dresses Co held 3 pink satin dresses with orange sashes, designed by Freda Swoggs.
These were valued at $120 each. During November 20X2, 12 more of the dresses were delivered as follows.
Date Units received Purchase cost per dress
10 November 4 $125
20 November 4 $140
25 November 4 $150
A number of the pink satin dresses with orange sashes were sold during November as follows.
Date Dresses sold Sales price per dress
14 November 5 $200
21 November 5 $200
28 November 1 $200
Required
Calculate the gross profit (sales – (opening inventory + purchases – closing inventory)) from selling the pink satin
dresses with orange sashes in November 20X2, applying the following principles of inventory valuation.
(a) FIFO
(b) LIFO
(c) AVCO
Solution
(a) FIFO
Date Cost of sales Total Closing inventory
$
$
14 November
3 units × $120
+ 2 units × $125
610
21 November
2 units × $125
+ 3 units × $140
670
28 November
1 unit × $140
140
Closing inventory
4 units × $150
600
1,420
600
FA
S
T F
O
RWAR
D
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
(b) LIFO
Date Cost of sales Total Closing inventory
$
$
14 November
4 units × $125
+ 1 unit × $120
620
21 November
4 units × $140
+ 1 unit × $120
680
28 November
1 unit × $150
150
Closing inventory
3 units × $150
+ 1 unit × $120
570
1,450
570
(c) AVCO
Balance in
Cost of
Closing
Units
Unit cost
Inventory
sales
inventory
$
$
$
$
1 November
3
120.00
360
10 November
4
125.00
500
7
122.86
860
14 November
5
122.86
614
614
2
246
20 November
4
140.00
560
6
134.33
806
21 November
5
134.33
672
672
1
134
25 November
4
150.00
600
5
146.80
734
28 November
1
146.80
147
147
30 November
4
146.80
587
1,433
587
Profitability
Weighted
FIFO
LIFO
average
$
$
$
Opening inventory
360
360
360
Purchases
1,660
1,660
1,660
2,020
2,020
2,020
Closing inventory
600
570
587
Cost of sales
1,420
1,450
1,433
Sales (11 × $200)
2,200
2,200
2,200
Gross profit
780
750
767
Some questions will ask you for an inventory valuation figure and some will ask for a profit figure. Make sure you read
the question carefully.
5.2 Profit differences
In the example above, different inventory valuation methods produced different costs of sale and hence different
gross profits. As opening inventory values and purchase costs are the same for each method, the different costs of
Assessment
focus point
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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sale are due to different closing inventory valuations. The differences in gross profits therefore equal the differences
in closing inventory valuations.
The profit differences are only temporary. In the example, the opening inventory in December 20X2 will be $600, $570
or $587, depending on the inventory valuation method used. Different opening inventory values will affect the cost of
sales and profits in December, so that in the long run, inequalities in costs of sales each month will even themselves out.
It is highly likely that your assessment will include a question on inventory valuation and the pricing of materials issues
and/or the effect on profit as it is relatively easy to set questions on this topic.
6 Documentation
You will appreciate that businesses need to keep records of all materials movements in and out of the business and
within the business. This is achieved using a variety of documents. These include the following.
(a) Delivery note
When goods are received from a supplier, the supplier usually produces a delivery note and asks the storekeeper
receiving the goods to sign the note as proof of delivery.
(b) Goods received note
When goods are received from a supplier, the storekeeper fills in a goods received note and sends a copy to the
purchasing department and the accounts department.
(c) Materials requisition
When a department requires materials from stores, a materials requisition must be filled in and authorised.
(d) Materials returned note
If it turns out that the department doesn’t need as much material as first thought, the excess material should be
returned to stores with a materials returned note.
(e) Materials transfer note
Sometimes materials are transferred from one department to another. When this happens a materials transfer
note should be raised.
Assessment
focus point
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
Chapter Roundup
•
The correct pricing of issues and valuation of inventory are of the utmost importance because they have a direct effect
on the calculation of profit. Several different methods can be used in practice.
•
FIFO assumes that materials are issued out of inventory in the order in which they were delivered into inventory: issues
are priced at the cost of the earliest delivery remaining in inventory.
•
LIFO assumes that materials are issued out of inventory in the reverse order to which they were delivered: the most
recent deliveries are issued before earlier ones, and issues are priced accordingly.
•
The cumulative weighted average pricing method (or AVCO) calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory remaining would have the same unit
valuation. The average price is determined by dividing the total cost by the total number of units.
A new weighted average price is calculated whenever a new delivery of materials is received into store. This is the key
feature of cumulative weighted average pricing.
•
Each method of inventory valuation (usually) produces different figures for both the value of closing inventories and also
the cost of material issues. Since materials costs affect the cost of production, and the cost of production works through
eventually into the cost of sales (which is also affected by the value of closing inventories), it follows that different
methods of inventory valuation will provide different profit figures.
Quick Quiz
1 Which of the following are true?
I With FIFO, the inventory valuation will be very close to replacement cost.
II With LIFO, inventories are issued at a price which is close to the current market value.
III Decision making can be difficult with both FIFO and LIFO because of the variations in prices.
IV A disadvantage of the weighted average method of inventory valuation is that the resulting issue price is rarely an
actual price that has been paid and it may be calculated to several decimal places.
A I and II only
B I, II and III only
C I and III only
D I, II, III and IV
2 LIFO is essentially an historical cost method.
True
False
3 Fill in the blanks.
When using ………………….. method of inventory valuation, issues are at a price which approximates to economic
cost.
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Part A Cost determination and behaviour ⏐ 5: Inventory valuation
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4 Choose the correct words from those highlighted.
AVCO requires that a new weighted average price is calculated whenever materials are issued/a new delivery of
materials is received/at the end of each accounting period.
5 A wholesaler had opening inventory of 600 units of product C valued at $50 per unit at the beginning of May. The
following receipts and sales were recorded during May.
Date 2 May 12 May 21 May 29 May
Receipts 800
Issues 500 400 150
The purchase cost of receipts was $51.50 per unit. Using a weighted average method of valuation, calculate the value of
closing inventory at the end of May.
Answers to Quick Quiz
1 D All of the statements are true
2 False. FIFO is an historical cost method
3 LIFO
4 When a new delivery of materials is received
5 $17,967
Working
Units
$
Opening inventory
600 × $50
600
30,000
Issue on May 2
500 × $50
(500
)
(25,000)
100
5,000
Receipts on May 12
800
41,200
900
46,200
Issues on May 21 and May 29
(46,200/900) × (400 + 150)
(550
)
(28,233)
350
17,967
Now try the questions below from the Question Bank
Question numbers Page
21–25 355
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5: Inventory valuation ⏐ Part A Cost determination and behaviour
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Topic list Learning outcomes Syllabus references Ability required
1 Breakeven analysis and contribution B(v) B(4) Comprehension
2 Breakeven point B(vi) B(5) Application/Analysis
3 The contribution/sales (C/S) ratio B(vi) B(5) Application/Analysis
4 The margin of safety B(vi) B(5) Application/Analysis
5 Breakeven arithmetic and profit targets B(vi) B(5) Application/Analysis
6 Breakeven charts and profit/volume graphs B(vii) B(5) Application
7 Limitations of breakeven analysis B(v) B(5) Comprehension
8 Limiting factor analysis B(viii) B(6) Application
Breakeven analysis
and limiting factor
analysis
Introduction
You should by now realise that the cost accountant needs estimates of fixed and variable
costs, and revenues, at various output levels. Cost accountants must also be fully aware of
cost behaviour because, to be able to estimate costs, they must know what a particular cost
will do given particular conditions.
An understanding of cost behaviour is not all that you may need to know, however. The
application of breakeven analysis, which is based on cost behaviour principles and marginal
costing ideas, is sometimes necessary so that the appropriate decision-making information
can be provided. As you may have guessed, this chapter is going to look at that very topic.
We're also going to take a look at limiting factor analysis, another technique using marginal
costing ideas. This one helps us to determine the profit-maximising production or sales mix.
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