Chapter 7 ACC PDF

## Chapter 7: Cost of Sales and Inventories ### Introduction - Learning outcomes: - Record and account for transactions and events resulting in income, expenses, assets, liabilities, and equity in accordance with the appropriate basis of accounting and the laws, regulations, and accounting sta...

## Chapter 7: Cost of Sales and Inventories ### Introduction - Learning outcomes: - Record and account for transactions and events resulting in income, expenses, assets, liabilities, and equity in accordance with the appropriate basis of accounting and the laws, regulations, and accounting standards applicable to the financial statements. - Identify the main components of a set of financial statements and specify their purpose and interrelationship. - Prepare and present a statement of financial position, statement of profit or loss, statement of changes in equity, and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity. - Specific syllabus learning outcomes are: 1d, 3a, 3c. - Syllabus links: The material in this chapter is developed further in the Accounting module, and later in Professional Level Financial Accounting and Reporting. - Examination context: Questions on the topics in this chapter will be set as multiple choice, multi-part multiple choice, or multiple-response questions, some of which may involve calculations. Very often double entry questions are phrased in terms of preparing a journal. In the exam, you may be required to: - Identify the accounting principles behind the cost of sales. - Specify the components of the cost of sales in the statement of profit or loss. - Use margin and mark-up to calculate revenue or cost of sales. - Identify the accounting principles behind accounting for inventory. - Identify the purpose of an inventory count. - Specify what is included in the cost of inventory. - Identify the correct value for inventory using FIFO and AVCO. - Calculate net realizable values. - Use margin and mark-up to calculate closing inventory. - Identify how to account for drawings of inventory and for substantial losses of inventory. - Identify how to account for closing inventory in the ledger accounts. - Calculate the figure in the statement of financial position for inventory. - Identify the effects of opening and closing inventory on gross and net profit in the statement of profit or loss. ### Learning Topics 1. **IAS 2, Inventories** - Section overview: IAS 2 prescribes the accounting treatment for inventories. - Inventories are assets that are: - Held for sale in the ordinary course of business; - In the process of production for such sale; or - In the form of materials or supplies to be consumed in the production process or in the rendering of services. - Objective: The objective of IAS 2, Inventories is to prescribe the accounting treatment for inventories. In particular, it provides guidance on the determination of cost and its subsequent recognition as an expense, including any write-down to net realizable value. - Inventories: Assets: - Held for sale in the - In the process of production for such sale; or - In the form of materials or supplies to be consumed in the production process or in the rendering of services. - Inventories can include: - Goods purchased and held for resale - Finished goods - Work in progress (part completed goods) - Raw materials awaiting use 2. **Cost of Sales** - Section overview: Cost of sales comprises: - Opening inventory - Purchases - Delivery inwards - Closing inventory - Cost of sales - Cost of sales is deducted from revenue (sales) to arrive at gross profit. - When a large amount of purchased or manufactured items are stolen or lost, we must remove them from the cost of sales and treat them as an administrative expense, so as not to distort gross profit. - The cost of sales is deducted from revenue in an entity’s statement of profit or loss. Because it results in the gross profit it has long been regarded as a key figure in the financial statements. - Definition: Cost of sales: Opening inventory + purchases + delivery inwards - closing inventory = cost of sales. This amount is then deducted from revenue to arrive at the business’s gross profit. - Inventory, both opening and closing, features in the statement of profit or loss. - Unsold goods at the end of a reporting period: Goods might be unsold at the end of a reporting period and so still be held in inventory. Under the accruals concept, the cost of these goods should not be included in cost of sales as they have not contributed to revenue generation. Instead, the goods should be carried forward and matched against revenue in subsequent periods when they are sold. - Worked example: Closing inventory: The Umbrella Shop's financial year ends on 30 September each year. On 1 October 20X4 it had no goods in inventory. During the year to 30 September 20X5, it purchased 30,000 umbrellas costing CU60,000 from its suppliers. It resold the umbrellas for CU5 each, and sales for the year amounted to CU100,000 (20,000 umbrellas). At 30 September 20X5 there were 10,000 unsold umbrellas left in inventory, valued at cost of CU2 each. - Requirement: What was The Umbrella Shop’s gross profit for the year? - Solution: The Umbrella Shop purchased 30,000 umbrellas, but only sold 20,000. Purchase costs of CU60,000 and sales of CU100,000 do not relate to the same quantity of goods. The gross profit for the year should be calculated by 'matching' the sales value of 20,000 umbrellas sold with the cost of those 20,000 umbrellas. The cost of sales in this example is therefore the cost of purchases minus the cost of goods in inventory at the year end. - Worked example: Opening and closing inventory: In its next reporting period, 1 October 20X5 to 30 September 20X6, The Umbrella Shop purchased 40,000 umbrellas at a total cost of CU95,000 and sold 45,000 umbrellas for CU230,000. At 30 September 20X6 it had (10,000+ 40,000 45,000) 5,000 umbrellas left in inventory, which together had cost CU12,000. - Requirement: What was The Umbrella Shop’s gross profit for the year to 30 September 20X6? - Solution: In this reporting period, it purchased 40,000 umbrellas to add to the 10,000 it already had in inventory at the start of the year. It sold 45,000, leaving 5,000 umbrellas in inventory at the year end. Once again, gross profit should be calculated by matching the value of 45,000 units of sales with the cost of those 45,000 units. - Cost of sales: - Opening inventory value - Add cost of purchases (or, for a manufacturing company, the cost of production) - Add cost of delivery inwards (see below) - Less closing inventory value - Equals cost of sales - In other words, to match 'sales' and 'cost of sales', it is necessary to adjust the cost of goods purchased or manufactured to allow for increases or reductions in inventory levels during the period. - Interactive question 1: Gross profit: On 1 January 20X6, Grand Union Food Stores had goods in inventory valued at CU6,000. During 20X6, it purchased supplies costing CU50,000. Sales for the year to 31 December 20X6 amounted to CU80,000. The cost of goods in inventory at 31 December 20X6 was CU12,500. - Requirement: Calculate Grand Union Food Stores’ gross profit for the year. 3. **Delivery Costs** - Delivery costs refer to all costs of transporting purchased goods from the supplier to the customer. - One party has to pay for these delivery costs: sometimes the supplier pays (in which case the customer has no costs to record) and sometimes the customer pays. - When the supplier pays, the cost to the supplier is known as delivery outwards as the goods are going out of the business. When the customer pays, the cost to the customer is known as delivery inwards as the goods are coming into the business. - The cost of delivery outwards is a distribution cost deducted from gross profit in the statement of profit or loss. - The cost of delivery inwards is added to the cost of purchases and is therefore included in the calculation of cost of sales and gross profit. - Worked example: Delivery costs: Clockers is a company which imports and resells clocks. It pays for the costs of delivering the clocks from its supplier in Switzerland to the shop in Wales. Clockers resells clocks to other traders throughout the country, paying delivery costs for deliveries from its business premises to the customers. On 1 July 20X5, Clockers had clocks in inventory valued at CU17,000. During the year to 30 June 20X6, it purchased more clocks for CU75,000. Delivery inwards amounted to CU2,000. Sales for the year were CU162,100. Other business expenses amounted to CU56,000, excluding delivery outwards which cost CU2,500. The value of clocks in inventory at 30 June 20X6 was CU15,400. - Requirement: Prepare the statement of profit or loss of Clockers for the year ended 30 June 20X6. - Solution: Clockers - Statement of profit or loss for the year ended 30 June 20X6 - Sales - Opening inventory - Purchases - Delivery inwards - Less closing inventory - Cost of sales - Gross profit - Delivery outwards - Other expenses - Net profit 4. **Service Organizations:** - So far, we have considered cost of sales for businesses that sell products to customers, and therefore have to make adjustments for opening and closing inventories when calculating cost of sales. Many businesses, such as professional services firms or providers of data analytics services, provide their customers (or more accurately clients) with services rather than products and therefore need to calculate their cost of sales differently. - Cost of sales for a service organization typically includes the following: - Direct labor costs - this is the cost of any labor services directly related to the service provided. - Sales commission - if a business pays its employees a commission or bonus related to securing work, the cost of the commission paid should be included in cost of sales. - Materials used - some service organizations will have some materials costs despite being service providers. - Worked example: Service-related cost of sales: Skills Ltd provides workplace training for the employees of businesses operating in the hospitality sector. Skills Ltd operates from a single office location on which monthly rental payments are made. Training is always carried out remotely and the office is not used to deliver training. Skills Ltd has a receptionist and a number of sales agents who are each paid an annual salary. The sales agents are paid commission for every new contract they secure. Skills Ltd uses freelance experts who are paid a flat rate per day to design and run the training courses required by its clients. Some clients request that a hard copy of learning materials is printed by Skills Ltd and delivered to them in advance of the course. - Requirement: Explain whether the costs incurred by Skills Ltd can be included in its cost of sales. - Solution: - Cost: - Office rental: No - The office rental costs are not direct costs incurred in providing the service as the office is not used to provide training. - Receptionist staff salary: No - The receptionist’s salary is nota direct labour cost incurred in providing the service as the salary is paid regardless of whether the service is undertaken. - Sales agent salaries: No - The sales agent salaries are notdirect labour costs incurred in providing the service. - Sales agent commission: Yes - The commission is only paid when a new contract is secured and is therefore incremental tothe contract. - Freelance expert fees: Yes - Freelance experts are appointed to design and deliver courses as required by clients and are therefore incremental to the contract. - Printing and delivery of hard copy learning materials: Yes - The costs of printing anddelivering the hard copy materials are direct materialscosts and should be included in cost of sales. - Note: Costs which cannot be presented in cost of sales are included in other expense categories in the statement of profit or loss. Administrative expenses are often used. - Interactive question 2: Direct labour costs: ABC Accountants offers accounting and tax services to its clients. ABC Accountants is preparing its financial statements for the year end 31 August 20X5 and provides services to its clients which span its year-end. The following information is relevant to the preparation of the financial statements and tax return for a client engagement which spans ABC Accountants’ year end. - Requirement: Calculate the amount that should be included in ABC Accountants cost of sales at 31 August 20X5. 5. **Inventory Written Off or Written Down:** - A business might be unable to sell all the goods purchased, because before they can be sold they might: - Be lost or stolen - Be damaged and become worthless - Become obsolete or out of fashion; these might be thrown away, or sold off at a low price - When goods are lost, stolen or thrown away as worthless, the business will make a loss on those goods because their 'sales value' will be nil. - Similarly, when goods lose value because they have become obsolete or out of fashion and are sold off at a low price, the business will make a loss if their net realizable value is less than cost. - If, at the end of a reporting period, a business still has goods in inventory which are either worth less or worth less than their original cost, the value of the inventories should be written down to: - Nothing, if they are worthless; or - Their net realizable value if this is less than their original cost. - The cost of inventory written off or written down does not usually cause any problems in calculating the gross profit of a business, because the cost of sales already includes the cost of inventories written off or written down. - Worked example: Inventories written off and written down: Wagg ends its financial year on 31 March. At 1 April 20X5 it had goods in inventory valued at CU8,800. During the year to 31 March 20X6, it purchased goods costing CU48,000. Fashion goods which cost CU2,100 were held in inventory at 31 March 20X6, and Wagg believes that these can only now be sold at a sale price of CU400. Goods still held in inventory at 31 March 20X6 (including the fashion goods) had an original purchase cost of CU7,600. Sales for the year were CU81,400. - Requirement: Calculate Wagg’s gross profit for the year ended 31 March 20X6. - Solution: Initial calculation of closing inventory values: - Inventory destroyed or stolen and subject to an insurance claim: Where a material amount of inventory has been stolen or destroyed, including its cost in gross profit will give a very distorted idea of the business’s basic profitability. - Purchases will include the cost of goods that could not be sold, so the accrual principle is broken, yet they are not in closing inventory either, so it will look as if the business's gross margin on sales has fallen catastrophically. - There may be an amount of income as a result of an insurance claim, which cannot be included in cost of sales under the 'no offsetting' principle'. - Worked example: Material amount of inventory stolen: Frankie had CU15,000 of inventory as at 1 January 20X2. During the year to 31 December 20X2 they purchased inventory for CU98,000, incurring delivery inwards of CU150. They made sales of CU150,000, incurring delivery costs to her customers of CU2,400. At 31 December 20X2 Frankie realises that inventory costing only CU200 is left; goods costing CU18,000 have been stolen. - Requirement: Prepare Frankie’s statement of profit or loss assuming: (1) Frankie has relevant insurance and the insurer has agreed to pay a claim for 75% of the cost; and (2) Frankie does not have any insurance. - Solution: - Interactive question 3: Insurance claim: Inventory that cost Wasa Ltd CU64,500 was destroyed in a fire. The inventory was insured for 60% of its cost. Wasa Ltd made a claim on its insurance policy and the insurance company agreed to settle the claim. No amounts were received from the insurance company before the year end. - Requirement: Prepare a journal entry to account for this in Wasa Ltd’s accounting records. 6. **Accounting for Opening and Closing Inventories:** - Section overview: - In each reporting period, opening inventory is included in cost of sales, which is an expense in the statement of profit or loss: - DEBIT: Cost of sales - CREDIT: Inventory account (statement of financial position) - Closing inventory is deducted from cost of sales in the reporting period, so it can be carried forward and matched against the revenue it earns in the next period: - DEBIT: Inventory account (statement of financial position) - CREDIT: Cost of sales - As we have seen above, the cost of sales figure in the statement of profit or loss is summarised as: - Opening inventory - Plus purchases - Plus delivery inwards - Less closing inventory - Cost of sales - However, this formula hides three basic problems: - How do you manage to get a precise count of inventories held at any one time? - Once counted, how do you value the inventories? - Assuming the inventories are given a value, how does the double entry bookkeeping for inventories work? - The purpose of this chapter is to answer all three of these questions. In order to make the presentation a little easier to follow, we shall take the last question first. - Ledger accounting for inventories: As we saw above, cost of sales is presented in the statement of profit or loss but is calculated based on the totals of other ledger balances. Although a computerised accounting system will calculate cost of sales automatically, it is important that you understand the underlying adjustments that are being processed. As inventory is a statement of financial position balance, closing inventory at the end of one period becomes opening inventory at the start of the next period. Opening inventory needs to be transferred from the inventory account to the cost of sales account (as it will be sold in the period) using the following journal: - DEBIT: Cost of sales - CREDIT: Current assets - inventory - Purchases of inventories are transferred to a cost of sales ledger account via the following double entry: - DEBIT: Cost of sales - CREDIT: Purchases account - The opening inventories and the purchases represent the total amount of inventory that a business can sell in a period. The inventory account is only used at the end of a reporting period, when the business counts and values closing inventory, during the inventory count. Once an inventory count has been carried out and the business has a value for its closing inventory, the double entry is: - DEBIT: Current assets - inventory - CREDIT: Cost of sales - The closing inventory reduces cost of sales (as it represents amounts that have not been sold in the period). The debit balance on the closing inventory account represents a current asset in the statement of financial position. The balance on the cost of sales ledger account should then be transferred to the profit and loss ledger account as a component of the profit calculation at the end of the period. - DEBIT: Profit and loss ledger account - CREDIT: Cost of sales - Worked example: Accounting for inventories: A business has opening capital of CU2,000, represented entirely by inventory. During the first year’s trading, when the owner took no drawings, the following transactions occurred. - Purchases of goods for resale, on credit - Payments for trade payables - Sales, all on credit - Receipts from trade receivables - Non-current assets purchased for cash - Other expenses, all paid in cash - All 'other expenses' relate to the current year. Closing inventory is valued at CU1,800. - Requirements: - Prepare the ledger accounts, including a cost of sales ledger account and a profit and loss ledger account, for the 12-month reporting period. - Prepare a statement of financial position as at the end of the reporting period. - Solution: - CASH AT BANK ACCOUNT - CAPITAL - TRADE PAYABLES - PURCHASES - NON-CURRENT ASSETS - SALES - TRADE RECEIVABLES - OTHER EXPENSES - INVENTORY - COST OF SALES - PROFIT AND LOSS LEDGER ACCOUNT - Statement of financial position as at the end of the period - ASSETS - Non-current assets - Current assets - Inventory - Trade receivables - TOTAL ASSETS - CAPITAL AND LIABILITIES - Capital - At start of period - Profit for period - At end of period - Current liabilities - Bank overdraft - Trade payables - Total capital and liabilities - Interactive question 4: Journals for inventory: In its nominal ledger Wickham plc had a balance on its inventory account at 1 July 20X2 of CU23,490.At the end of the reporting period, 30 June 20X3, it had inventory of CU40,285. - Requirement: Prepare the journal entries to record the situation as at the end of the reporting period in the nominal ledger of Wickham plc. 7. **Adjusting the Initial Trial Balance:** - Section overview: - The closing inventory is often accounted for after the initial trial balance has been prepared. - A journal entry is required to adjust the initial trial balance to transfer opening inventories and purchases to cost of sales and record closing inventory. - A new cost of sales line is added to the trial balance as a result of the journal entries posted. - In the previous section we saw how closing inventory is accounted for in the ledger accounts. However, in a manual accounting system, the adjustment for closing inventory is often not accountedfor until after the initial trial balance has been extracted. Therefore, opening inventory and purchases appear on the initial trial balance. The initial trial balance needs to be adjusted to reflect that the business no longer has opening inventories (these have been sold in the year) and instead has closing inventories (which are carried forward as current assets to be sold in the following year) and that purchases have transferred to cost of sales. - The approach is as follows: - Calculate the value of closing inventories (see below). - Prepare the year-end journals for opening inventories, purchases and closing inventories (see above) and enter the journals as adjustment to the initial TB. - Worked example: Adjusting the initial trial balance for inventories: Sam's Music Shop initial trial balance as at 31 December 20X5 is as follows: - Ledger balance: - Cash at bank - Opening capital - Loan - Non-current assets - Trade payables - Expenses - Purchases - Sales - Trade receivables - Inventories at 1.1.X5 - Drawings - Closing inventories at 31 December 20X5 cost CU13,855. - Requirement: Adjust Sam’s initial trial balance to reflect closing inventories and calculate his net profit for the year. - Solution: The first step in adjusting the trial balance is to prepare the relevant journal entries as follows: - Prepare the journal entry to transfer opening inventories to cost of sales: - DEBIT: Cost of sales - CREDIT: Inventories (opening) - Recording opening inventories as a component of cost of sales - Prepare the journal entry to transfer purchases to cost of sales: - DEBIT: Cost of sales - CREDIT: Purchases - Recording purchases as a component of cost of sales - Prepare the journal entry for closing inventory: - DEBIT: Inventories (closing) - CREDIT: Cost of sales - Recording closing inventories as an asset at the year end - Next, you should adjust the initial trial balance to take account of these journals and calculate the final trial balance. - Sam's final trial balance will be as follows: - Ledger balance: - Initial trial balance - Debit - Credit - Adjustments - Debit - Credit - Final trial balance - Debit - Credit - Finally, the extended trial balance can be used to prepare the financial statements. - Sam's Music Shop - Statement of profit or loss for the year ended 31 December 20X5 - Revenue - Cost of sales * - Gross profit - Expenses - Net profit - Note that the cost of sales balance comprises the opening inventories + purchases - closing inventories, consistent with the calculation introduced previously. - Sam's Music Shop - Statement of financial position as at 31 December 20X5 - ASSETS - Non-current assets - Current assets - Inventories - Trade receivables - Total assets - CAPITAL AND LIABILITIES - Capital - At start of period - Profit for period - At end of period - Current liabilities - Bank overdraft - Trade payables - Total capital and liabilities 8. **Counting Inventories:** - Section overview: The inventory count establishes quantities held in inventory at the end of the reporting period. - Business trading is a continuous activity, but financial statements must be drawn up at a particular date. In preparing a statement of financial position it is necessary to 'freeze' the activity of a business so as to determine its assets, capital, and liabilities at that given moment. This includes establishing the quantities of inventories held. - In very small businesses, when a business holds easily counted and relatively small amounts of inventory, quantities of inventories held at the date of the statement of financial position can be determined by physically counting them in an inventory count. - It is more likely, however, that a business will hold considerable quantities of varied inventory and will use its computerised accounting system to maintain continuous inventory records. This means that the accounting system keeps a record for each line of inventory item, showing purchases and issues from the stores, and a running total. A few inventory line items are counted each day to make sure the records are correct - this is called a 'continuous' count because it is spread out over the reporting period rather than completed in one count at a designated time. - Once the quantity of inventories is determined then a policy is required for valuing the inventory. 9. **Valuing Inventories:** - Section overview: Inventory is valued at the lower of (historical) cost of purchase, and net realisable value (NRV). - NRV is the expected selling price less any costs to be incurred in achieving that sale. - Cost comprises: purchase price, delivery, import taxes and duties, and conversion costs to bring the item to its present location and condition. - Basic valuation: lower of cost and NRV: Inventory is normally valued at its - Context example: Lower of cost and NRV: A trader buys an item of inventory costing CU100. The item can usually be sold for CU140. The trader incurs CU5 of selling expenses for each item sold. Now suppose that the market slumps and the expected selling price is CU90. The item's NRV is then CU(90-5) = CU85 and the business will make a loss of CU15 (CU100-CU85) on the item. Assets should not be overstated, so the so loss will be recognised by valuing the item in the statement of financial position at its NRV of CU85. - Applying the lower of cost and NRV: If a business has many inventory items on hand the comparison of cost and NRV should be carried out for each item separately. It is not sufficient to compare the total cost of all inventory items with their total NRV, unless the items are interchangeable such as nuts or bolts. - Context example: Valuing each inventory item separately: A company has four items of inventory at the end of its reporting period. Their costs and NRVs are as follows: - Inventory item - Cost - NRV - Lower of Cost/NRV - It would be incorrect to compare total cost (CU113) with total NRV (CU135) and to state inventories at CU113 in the statement of financial position. The company can foresee a loss of CU6 on item 2 and this should be recognised immediately. If the four items are taken together in total the loss on item 2 is masked by the anticipated profits on the other items. By performing the cost/NRV comparison for each item separately the appropriate valuation of CU107 can be derived. This is the value which should appear in the statement of financial position. - Professional accountants must ensure that the NRV has been correctly determined and that the lower of cost and NRV principle is adhered to. - Interactive question 5: Inventory valuation: The following figures relate to inventory held at the end of the reporting period. - Item: - Cost - Selling price - Modification cost to enable sale - Selling costs - Units held - Requirement: Calculate the value of inventory for inclusion in the financial statements. 10. **Determining the Cost of Inventory:** - Inventories may be: - Raw materials or components bought from suppliers - Finished goods which have been made by the business but not yet sold - Part completed items - Goods purchased and held for resale - Definitions: - Cost of inventories: All costs of purchase, of conversion (eg, labour) and of other costs incurred in bringing the items to their present location and condition. - Cost of purchase: The purchase price, import duties and other non-recoverable taxes, transport, handling, and other costs directly attributable to the acquisition of finished goods and materials. - What is included in the total cost of an item of inventory? The total cost of an item of inventory includes all costs incurred in bringing the item to its present location and condition. This consists of: - The purchase cost of raw materials - Delivery inwards - Import taxes and duties - Conversion costs - Definition: - Conversion costs: Any costs involved in converting raw materials into final product, including labour, expenses directly related to the product and an appropriate share of production overheads (but not sales, administrative or general overheads). - Context example: Cost of manufactured goods: A business has the following details relating to production and sales for a reporting period: - Sales: 900 units at CU600 each - 1,000 units are produced with the following costs being incurred: - Opening inventory of raw materials: 200 units at CU100 each - Purchases of raw materials: 1,050 units at CU100 each - Closing inventory of raw materials: 250 units at CU100 each - Production wages - CU150,000 - Production overheads - CU100,000 - General administration, selling and distribution costs - CU100,000 - The cost of production should include an appropriate share of production wages and production overheads, but not non-production expenses. - The statement of profit or loss of this business for the reporting period is as follows: - What is the total cost of items left in inventory? A business may be continually adding items to finished goods inventory or purchasing a particular component. As each consignment is received from suppliers, or each finished goods batch is added to inventory, they are stored in the appropriate place, where they will be mingled with items already there. These goods are considered interchangeable in that the storekeeper would not distinguish between items when they issue items to production or to despatch. They will simply pull out the nearest item to hand, which may have arrived in the latest consignment/batch, in an earlier consignment/batch or in several different consignments/batches. There are several techniques which are used in practice to attribute a cost to interchangeable inventory items; remember that actual materials, components and finished goods items can be issued in any order irrespective of when each one entered inventory. - Definitions: - FIFO (first in, first out): Items are assumed to be used in the order in which they are received from suppliers, so oldest items are issued first. Inventory remaining is therefore the newer items and cost is measured as such. - LIFO (last in, first out): Items issued are assumed to be part of the most recent delivery, while oldest consignments are assumed to remain in the stores. LIFO is not allowed under IFRS Standards and it not considered further in Accounting. - AVCO (average cost): As purchase prices can change with each new consignment received, the average value of an item is constantly changing. Each item at any moment is assumed to have been purchased at the average price of all the items together, so inventory remaining is therefore valued at the most recent average price. - In the exam you may be asked to use the FIFO or AVCO method to determine the cost of inventory in the statement of financial position and the statement of profit or loss. You may be asked to comment on the impact of different cost estimation techniques on profit. - Worked example: FIFO and AVCO: To illustrate the FIFO and AVCO methods of valuing inventory, the following transactions will beused. - Transactions during May 20X7 - Quantity - Unit cost - Total cost - Closing balance 31 May - Quantity - Unit cost - Total cost - Notes: - Receipts mean goods are received into store. - Issues represent the issue of goods from store. - The problem is to put a valuation on the following: - The issues of goods - The closing inventory - Requirements: - How would issues of goods and closing inventory be valued using: - FIFO? - AVCO? - Solution: - FIFO: FIFO assumes that goods are issued out of inventory in the order in which they were delivered into inventory, ie, the cost of issues is deemed to be at the cost of the earliest delivery remaining in inventory. - The cost of issues and of closing inventory using FIFO would be as follows: - Date - Quantity - Issued - CU Cost of issues - Closing inventory - AVCO: AVCO may be used in various ways in costing inventory issues. The most common is the cumulative weighted average pricing method illustrated below. - A weighted average cost for all units in inventory is calculated. Issues are valued at this average cost, and the balance of inventory remaining has the same unit cost. - A new weighted average cost is calculated whenever a new delivery of goods into store is received. - - Date - Received - Issued - Balance - Total inventory value - Unit cost - Cost of issue - Closing inventory value - For this method too, the cost of goods issued plus the cost of closing inventory equals the cost of purchases plus the cost of opening inventory (CU1,916). 11. **Inventory Valuations and Profit:** - FIFO and AVCO each produced different costs, both of closing inventories and also of materials issues. Since raw material costs affect the cost of production, and the cost of production works through eventually into the cost of sales, it follows that different methods of inventory valuation will provide different profit figures. - Worked example: Inventory valuations and profit: On 1 November 20X2 a company held 300 units of finished goods in inventory. These cost CU3,600. During November 20X2 three batches of finished goods were received into store from the production department, as follows: - Date - Units received - Production cost per unit - Finished goods sold during November 20X2 were as follows. - Date - Units sold - Sale price per unit - Requirements: - Calculate the amount of closing inventory if the FIFO method is