In simplified terms, inventory consists of items which the company owns but has not yet sold and/or consumed. Inventory is shown under the head current asset on the balance sheet because in the normal operating cycle, the company usually converts the goods into cash.
Inventory for a manufacturing company consist of:
- Raw materials
- Finished goods
Raw materials are the items that is required to produce the finished product. For example in sarees, raw material can be silk fabrics. Partial completed goods in the process of manufacturing is known as work-in-progress. Finished goods are the completed items ready for shipment to customers.
This means inventory is the items that are purchased and/or manufactured for sale to customers. To find out it’s cost, company uses different methods best suitable to the business. Most common methods to calculate cost are FIFO, LIFO and Average cost.
Let us discuss these methods in detail;
Under FIFO method, its assumed that the first items placed in inventory are the items sold first. This means when one of the items sold, the oldest cost of an item in the finished goods will be assumed that has been removed.
The oldest cost will be reported as cost of goods sold. As a result of this valuation, recent costs of an item will always be the value of the inventory and such value will be reported on the balance sheet under the head current asset.
In LIFO, its assumed that the newest items are removed first. This means when you are selling one of the product, cost of the last stock entered to the inventory will be considered as removed first.
The latest cost will be reported as cost of goods sold and the old cost will be shown as inventory cost on the balance sheet. In this case, profitability will get affected when cost of goods to be sold is continuously rising.
In average costing method, per unit cost is calculated on the basis of the average cost of all similar goods in the inventory. To get average cost per unit, you are required to divide total cost of the goods by the total number of items available for sale.
Average costing is also known as weighted average cost method. It will be useful when prices are frequently going up and down.
Management is free to select any method that they feel is most appropriate for the business, but once its selected it must be applied consistently.