Inventory Valuation series-Part 1

What Is Inventory Valuation?

Inventory valuation is the process of assigning a monetary value to the inventory items that the company holds- whether raw materials, work-in-progress (WIP), or finished goods.

What is its role?

The inventory value determines and impacts

• The cost of inventory shown on the balance sheet
• The cost of goods sold (COGS) shown on the income statement
• Gross Profit
• Net Income
• Financial ratios

What are the Key Components of Inventory Cost?

Inventory cost includes:

• Direct materials (raw materials used in production)
• Direct labor (wages for workers directly involved)
• Manufacturing overhead (utilities, depreciation, etc.)
• Freight and duties (if applicable) (as-2 freight entry)
• Other costs to bring inventory to its current condition and location

Types of techniques:

While valuing inventory, we have to decide what item of costs are included in unit cost. The process of determining which item of costs goes into the unit cost is called Inventory valuation technique.
Value of inventory changes according to the costing Technique we adopt.

There are various techniques available like variable costing (only variable pdtn cost) or Absorption costing (all pdtn cost) or Throughput Costing (only direct material), marginal costing (additional cost of producing one more unit). But absorption costing is the only technique where all manufacturing costs are absorbed into the cost of inventory.

Absorbption defined:

The term absorption refers to the process of allocating overheads to products. The cost elements that are included in inventory as per absorption costing are:

• Direct costs: Raw materials, direct labor
• Indirect costs: Systematically allocated fixed and variable production overheads like Factory rent, utilities, depreciation, indirect labor (i.e., overhead)

Going by the name and definition, absorption costing is the only technique, that aligns with Ind AS-2’s definition of 'cost' that includes absorbed 'overheads'.

Obviously, Absorption costing is also the one that is permitted under Ind AS 2 and IFRS for external reporting.

Connection: Absorption costing is the method, inventory valuation is the outcome.

Approaches under Absorption costing

Absorption costing requires that inventory valuation must include both variable and fixed manufacturing overheads. Businesses may apply this principle using different valuation method - such as the actual cost method, the standard cost method (with variance adjustments), or the retail method.

The key requirement is that regardless of whichever method is chosen, all manufacturing costs must be absorbed into inventory - including allocated fixed overheads. That’s the defining feature of absorption costing.

1. Actual cost method

   This method of absorption is based on actuals

   1. All the elements of cost including overheads are absorbed using actual rates.
   2. Required for External financial reporting under Ind AS 2.
   3. Most accurate for industries with detailed cost tracking (e.g., manufacturing, construction).
   4. Inventory Value = Total Production Cost per Unit × Number of Units in Inventory

2. Standard cost method

   The method of absorption is based on pre-determined rate (standard rate), with variance adjustments.

   1. Uses budgeted or pre-determined standard costs for materials, labour and overhead.
   2. Variance, if any must be regularly reviewed and adjusted to reflect actual conditions.
   3. Used for internal control, variance analysis and budgeting.
   4. Accepted under Ind AS 2, if it approximates actual cost reliably.

3. Retail method:

   This method Estimates inventory cost by deducting a gross margin from the sales value.

   1. Often used by retailers considering practicality where inventory items are rapidly changing and
   2. Where tracking individual item cost is impractical because the Inventory turnover is high and there are large volume of similar items

In this article i have discussed about basics of inventory valuation. In subsequent articles, i will discuss in detail the activity flow and accounting entries under actual cost method and standard cost method