Understanding Inventory Valuation

Introduction

The latest edition of the International Valuation Standards (IVS) as at the time of putting up this article issued on 31st July, 2021 by the International Valuation Standards Committee (IVSC) is International Valuation Standards (IVSs) titled IVS 2022 as they became effective on 31st January 2022.  

The 2022 edition of IVS replaced IVS 2020 and still consists of the existing five general standards, but now has eight asset standards in the same arrangement (IVS 200 to 500) save other inclusions and amendments.

• Businesses and Business Interests (IVS 200)
• Intangible Assets (IVS 210)
• Non-Financial Liabilities (IVS 220)
• Inventory (IVS 230) just included in the IVS
• Plant and Equipment (IVS 300)
• Real Property Interests (IVS 400)
• Development Property (IVS 410)
• Financial Instruments (IVS 500)

Inventory Valuation: In line with the International Valuation Standard 2022 (Asset Standards IVS 230) inventory broadly includes raw materials, work–in–process and goods awaiting sale (i.e, finished goods). Here, Valuation standard focuses on valuation of inventory of physical goods that are not real property. Some customers seeking funding/financing do not have real estate property/asset to pledge as collateral. Hence, they may choose to use their inventory as collateral.

It is the responsibility of a valuer to understand the purpose of a valuation and whether the inventory should be valued, whether separately or grouped with other assets. Hence, on several occasions, valuers have been asked to value inventory as part of general consulting, collateral lending, transactional support engagements and insolvency.

For example, a customer seeking finance up to the tune of N10,000,000.00 (Ten Million Naira Only) may not own any real estate asset to be pledged for secured lending, but can have goods worth over N50,000,000.00 (Fifty Million Naira Only) in the store/shop. The valuer would be called upon to assess these stock/inventory for the lender, by visiting the location, determine if the goods actually belong to the customer, count one by one, and check the quality and condition, before going ahead to determine the value of the goods awaiting to be sold. Upon determining the value, the lender is advised on the forced Sale Value and how much to advance to the customer based on the type of goods being traded.

Inventory valuation methods

There are several methods, but we would focus on the most frequently mentioned which are the following: FIFO, LIFO, WAC, and FEFO

Method 1: First in, first out (FIFO)

FIFO (first in, first out). It states that the first products to be purchased are the first to be sold, with the most recent items remaining in inventory. The principle under this approach is to sell those items that have been in inventory the longest, thus reducing the risk of obsolescence or expiration. Eg. a pharmaceutical company selling Paracetamol would likely sell those purchased in 2021 first before those purchased in year 2023. This eliminates the idea of selling old stock.

With FIFO, the warehouse’s remaining inventory is valued at a lower price because they tend to cost less than those that were just purchased.

Method 2: Last in, first out (LIFO)

The last units to enter will be the first to be sold in this valuation method, which is the opposite of FIFO.

Since it is the opposite of FIFO, it is not a method that is frequently used in practice but is frequently taught in academic settings.

Using same example of a pharmaceutical company selling Paracetamol, the company would likely sell those purchased in 2023 first before those purchased in year 2021. This approach is centred on profit but also increases the amount of taxes owed.

Method 3: Weighted Average

In this method, the cost of the inventories that are currently on hand is averaged; as a result, the average is updated for each unit that enters (those that are purchased).

WAC is a middle-ground method where the cost of finished goods is divided by the number of inventory units available for sale. 

In other words, this method involves dividing the price of the goods being sold by the quantity of them we have on hand.

Remember that the items that are for sale are a combination of those that were in the initial inventory and those that are being bought.
The amount we arrive at after dividing is used to determine the cost of the initial inventory or the cost of goods sold.

As a result, the value of our inventory is calculated as the sum of the costs of our oldest and most recent purchases.

This method is accepted by International Accounting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). It is usually one of the most widely used because of its ease of application.

Method 4: First Expired, First Out (FEFO)

While there are a number of far more specific inventory valuation methods to choose from, the last we will look at is FEFO or First Expired, First Out. FEFO is a necessary option for manufacturers with a high volume, high-speed process that produces perishables – items with a specific shelf life and expiration. This includes dairy, meat, pharmaceuticals, and other consumables that must be used by a specific date. FEFO is a lot like FIFO, except that the guiding principle is to use the expiration date of stock items instead of their arrival to inventory to designate what to use first. 

For example, a customer seeking finance up to the tune of ₦10,000,000.00 (Ten Million Naira Only) may not own any real estate asset to be pledged for secured lending, but can have goods worth over ₦50,000,000.00 (Fifty Million Naira Only) in the store/shop. The valuer would be called upon to assess these stock/inventory for the lender, by visiting the location, determine if the goods actually belong to the customer, count one by one, and check the quality and condition, before going ahead to determine the value of the goods awaiting to be sold. Upon determining the value, the lender is advised on the forced Sale Value and how much to advance to the customer based on the type of goods being traded.

WORKED Example inventory valuation

Let’s develop the examples based on the following data:

• On May 4, 215 units are purchased at a price of N110
• On May 8, 400 units are purchased at a price of N100.
• On May 17, 590 units are sold at a price of N240.
• On May 22, 200 units are purchased at a price of N105.
• On May 30, 175 units are sold at a price of N210.

The costs per unit are shown in the table for each method.

FIFO Example

1. We start by saying that the value per unit for the May 4 purchase is N110. Therefore, 215 units purchased at a cost of N110 each, gives us a total of N23,650 in inventory. The units we are left with in inventory are the same 215 units, plus the balance.
2. On May 8 we purchased 400 units at a cost of N100 each. Therefore we added N40,000 to our inventory balance. This is likewise reflected in the inventory balance. Take into account the 215 units from the previous transaction that in the event of a sale, will be the first to go.
3. Of the 590 units that are sold on May 17, the 215 units that were in inventory at N110 (those of March 4) are sold first, which corresponds to a cost of N23,650 (215 * 110).
4. Then the remaining 375 units are sold (from the May 8 purchase) for a selling cost of N37500 (375 * 100). There are 25 units left in inventory.

We proceed in the same way for the rest of the movements. If you get lost, ask in the comments!

This is how our FIFO example is solved:

FIFO		Purchases			Sales			Balances
date	Details	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value
May 4	Abaya	215	N110	N23,650				215	N110	N23,650
May 8	Abaya	400	N100	N40,000				400	N100.	N40,000
May 17	Abaya				215	N110	N23,650
May 17	Abaya				375	N100	N37,500	25	N100.	N2,500
May 22	Abaya	200	N105	N21,000				200	N105.	N21,000
May 30	Abaya				25	N100	N2,500
May 30	Abaya				150	N105	N15,750	50	N105.	N5,250

The cost of sales is calculated by adding up the sales of all periods. When added together, we obtain N79,400

LIFO example

1. Same procedure as fiscal year PEPS
2. Same procedure as the PEPS exercise. Bear in mind that the units of this purchase will be the first to be sold (because they are the last ones purchased).
3. The sale of 519 units is generated, of which 400 units are sold first (the last to enter, those of May 8) for a value of N100 each, for a total of N40,000 in units sold.
4. Then 190 units are sold for N110 (those left over from May 4) for N20,900. With this, we see that we have 25 units left over (215 left over – 190 sold) representing N2750.

In the same way we make the calculations for the movements of May 22 and 30.

LIFO		Purchases			Sales			Balances
date	Details	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value
May 4	Abaya	215	N110	N23,650				215	N110	N23,650
May 8	Abaya	400	N100	N40,000				400	N100	N40,000
May 17	Abaya				400	N100	N40,000
May 17	Abaya				190	N110	N20,900	25	N100	N2,750
May 22	Abaya	200	N105	N21,000				200	N105	N21,000
May 30	Abaya				175	N105	N18,375	25	N105	N2,625

Adding up the sales for all periods, we obtain a total cost of sales of N79,275.

Weighted average example

1. We purchase 215 units at a price of  N110, which gives us a value of 23,650. The balance in inventory we calculate the value of the unit by dividing the total cost by the number of units (N23,650/215 units). This gives us N110 per unit.
2. 400 units are purchased at a price of N100 each, which represents a total value of N40,000. In balance we add both the units purchased and the balance to calculate the value per unit. In units we get 615 (215 units from the March 4 purchase and 400 from this purchase) which represents N63,650 (N23,650 from the March 4 purchase and N40,000 from this purchase). We calculate the value per unit by dividing N63,650 by 615 units, this gives us N103.5 per unit.
3. 590 units are sold at just the price we calculated in the previous point (103.5). There are 25 units left in inventory (615 that were in balance – 590 from this sale). The total value in balance is N2,587 (63,650 from the previous purchase – 61,063 from this sale). The value per unit is obtained by dividing N2587 by 25.

We proceed in the same way for the other movements and this is what we get:

LIFO		Purchases			Sales			Balances
date	Details	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value	Qty	Unit Value	Total Value
May 4	Abaya	215	N110	N23,650				215	N110	N23,650
May 8	Abaya	400	N100	N40,000				615	N103.5	N63,650
May 17	Abaya				590	N103.5	N61,063	25	N103.5	N2,587
May 22	Abaya	200	N105	N21,000				225	N104.8	N23,587
May 30	Abaya				175	N105	N18,346	50	N104.8	N5,242

The cost of sales with the weighted average method is N79,408.

At this point, you may be asking yourself, why did I buy the units at one price and then the balance reflects another? The reason is in the cost of sales.

More article HERE and Here

This article expresses a personal opinion as well as excerpts from International Valuation Standards 2022, RICS Global Valuation Standard 2022 other written articles found on the sites referenced above and does not in any way substitute for such professional advice or services and it should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business, without consulting a qualified real estate or financial Advisor.

Ademola Ladega (ANIVS, RSV MNIM, FIMC) is the founder and managing partner of AOL Consult (www.aolmanagementconsult.com.ng) He is a highly experienced real estate consultant with field/practical experience spanning over 14 years, having previously worked at Ismail and Partners, where he contributed a great deal to the success of the firm and rose to the position of the Head of Valuation and Senior Associate. He is presently serving as the Secretary of the Plant and Equipment Faculty/Professional Group of the Nigeria institution of Estate Surveyors and Valuers, having been appointed in July, 2020 

Mr. Ladega has extensive experience of providing valuation services in Nigeria to large public and private companies in many sectors including utilities, banking, insurance, financial services, agro-industrial, shipping, commercial and trading sectors. As well as experience in reporting in accordance with the regulatory requirements of Nigeria, in full compliance with ESVARBON Nigeria Valuation Standards (Green Book) 2018 and other standards such as IPSAS, IFRS, RICS,  and IVS 2022