About Inventory Valuation
Inventory is the lifeline of any manufacturing enterprise, be it parts, sub-assemblies, raw materials, semi-finished, finished products, and even repair, maintenance, and operating goods. Every inventory item holds a certain value and manufacturers have to calculate this value accurately at the end of the financial year. This is called Inventory Valuation.
Let’s take an example,
A manufacturer who is into the production of fashion clothing such as t-shirts, trousers, shirts, etc. has inventory in the form of fabric materials, buttons, zippers, threads, dyes, printing designs, etc. It also includes packaging materials, tag cards, and cartons.
All of these if unsold or unused are called inventory stock and considered a current asset for the organization. This means they hold a certain financial value till they are consumed to manufacture finished products and sold in the market.
Apart from materials, there are other factors as well that come under inventory valuation.
Direct Materials
As mentioned above, the cost of direct raw materials and semi-finished goods that go into the final product. This cost can be arrived at using actual cost or standard cost.
Direct Labor
To calculate inventory valuation, only the labor responsible to manufacture the product is taken into account. Factors such as wages, pension contributions, payroll taxes, insurance, etc. are taken into account while calculating inventory valuation.
Overhead Costs
Cost of utilities, rent, insurance, equipment, tools, maintenance, and repair incurred during goods production.
Transport & Logistics
Transportation and logistics costs that are incurred during transporting the goods within the facility and customer delivery.
Material handling
Costs incurred to ready the finished goods for customer shipment (goods picking, packing, shipping label generation, and final shipment).
Taxes
Any taxes paid to import raw materials.
Sunken Costs
Costs incurred due to an error in the manufacturing process.
Now, if the manufacturer has 500 t-shirts, 500 shirts, and 500 pairs of trousers left unsold at the end of the financial year, the value for each item needs to be calculated and accounted for in the company’s balance sheet.
The Role of Costing Methods in Inventory Valuation
There are several methods employed by manufacturers to arrive at the cost of an item. These are,
Actual Costs
Actual costs as the name suggests, are derived based on the actual cost incurred for materials, labor, and overheads. Actual costs are derived from landed costs.
Actual Cost = Direct Costs + Indirect Costs + Fixed Costs + Variable Costs + Sunken Costs
What is Landed Cost?
Landed cost is the total price of a product that a buyer has to pay after he/she receives it at the doorstep. Landed costs include manufacturing costs, shipment fees, taxes, insurance, packaging fees, material handling, etc.
Actual costs are usually compared with estimated or planned costs to arrive at a variance.
Standard Costs
Standard costs are pre-determined costs based on specific working conditions and taking into account, a standard time and cost measurement of machines, labor, and materials.
Standard costs are usually compared with the Actual Costs for maximum accuracy.
Importance of Inventory Valuation in Manufacturing
The manufacturer would have paid a certain value to procure, store, transport, and maintain raw materials. Also, these items would have been procured at different costs at different timelines of the year. Therefore, a certain valuation method needs to be adopted in order to arrive at a common cost.
Inventory valuation has a direct impact on the Cost of Goods Sold (COGS), gross income, margins, and profitability and therefore manufacturers should accurately calculate valuation costs. This also has an impact on tax filing and regulatory compliance.
Inventory Valuation Methods
FIFO (First In, First Out)
Most manufacturers use the FIFO method to evaluate their inventory. FIFO as the name suggests means that the first batch of products that they manufacture and sell is from the first batch of raw materials that they bought. They take into account the costs pertaining to the first batch of raw materials while calculating the inventory.
LIFO (Last In, First Out)
LIFO as the name suggests means that the first batch of products that they sell is from the last batch of raw materials.
