Inventory Valuation & Cost of Goods Sold (Methods, COGS, FIFO, LIFO, AVCO)

TAKEAWAYS:

• Inventory valuation determines COGS and ending inventory, directly affecting gross profit and tax liabilities.
• FIFO (First-In-First-Out) assumes oldest inventory is sold first; LIFO (Last-In-First-Out) assumes newest inventory is sold first; AVCO (Average Cost) uses a weighted average.
• Perpetual vs. Periodic Inventory Systems: Perpetual updates records after every transaction; periodic adjusts only at year-end.
• Inventory errors (over/understatement) distort COGS, net income, and balance sheet values.
• Nepali businesses (e.g., Daraz, NTC, local retailers) use these methods to manage stock and report profits accurately.
• Exam focus: Numerical problems (calculating COGS, ending inventory, and financial statement impacts) and method comparisons.

1. What is Inventory?

Inventory refers to goods held for sale or raw materials used in production. For businesses like Daraz (e-commerce), NTC (telecom goods), or a Kathmandu retail shop, inventory is a critical asset.

Why does inventory matter?

• It affects COGS, which is ~30-70% of sales revenue in most businesses.
• Misvaluing inventory can lead to incorrect profit reporting and tax disputes.

2. Inventory Valuation Methods

Three primary methods determine COGS and ending inventory:

3. How Each Method Works (With a Nepali Example)

Let’s take Kathmandu’s "Bhatbhateni", a retail shop selling rice.

Given Data (Chaitra 2080):

• Jan 1 (Chaitra 1): Beginning inventory = 500 kg @ Rs. 10/kg
• Jan 10 (Chaitra 10): Purchased 1,000 kg @ Rs. 12/kg
• Jan 15 (Chaitra 15): Sold 1,200 kg @ Rs. 20/kg

Step 1: Calculate COGS and Ending Inventory for Each Method

A. FIFO (First-In-First-Out)

1. First, sell oldest stock (500 kg @ Rs. 10):
   • COGS (500 kg) = 500 × Rs. 10 = Rs. 5,000
2. Next, sell remaining from newest stock (700 kg @ Rs. 12):
   • COGS (700 kg) = 700 × Rs. 12 = Rs. 8,400
3. Total COGS = Rs. 5,000 + Rs. 8,400 = Rs. 13,400
4. Ending Inventory = 300 kg @ Rs. 12 = Rs. 3,600

B. LIFO (Last-In-First-Out)

1. First, sell newest stock (1,000 kg @ Rs. 12):
   • COGS (1,000 kg) = 1,000 × Rs. 12 = Rs. 12,000
2. Next, sell remaining from oldest stock (200 kg @ Rs. 10):
   • COGS (200 kg) = 200 × Rs. 10 = Rs. 2,000
3. Total COGS = Rs. 12,000 + Rs. 2,000 = Rs. 14,000
4. Ending Inventory = 500 kg @ Rs. 10 = Rs. 5,000

C. AVCO (Weighted Average Cost)

1. Total cost of available units:
   • (500 × Rs. 10) + (1,000 × Rs. 12) = Rs. 17,000
2. Total units available = 500 + 1,000 = 1,500 kg
3. Weighted avg. cost = Rs. 17,000 / 1,500 = Rs. 11.33/kg
4. COGS (1,200 kg) = 1,200 × Rs. 11.33 = Rs. 13,600
5. Ending Inventory (300 kg) = 300 × Rs. 11.33 = Rs. 3,400

TABLE: Comparison of COGS and Ending Inventory

4. Which Method is Best? (Advantages & Disadvantages)

5. Perpetual vs. Periodic Inventory Systems

MERMAID DIAGRAM: Inventory System Flow

flowchart TD
    A["Transaction Occurs"] --> B{"Perpetual?"}
    B -->|"Yes"| C["Update Inventory & COGS Immediately: Barcode/ERP System"]
    B -->|"No"| D["Wait Until Year-End"]
    D --> E["Physical Count & Reconciliation"]
    E --> F["Calculate COGS & Ending Inventory: Year-End Adjustment"]
    C --> G["Real-Time Financial Statements"]
    F --> G

6. Impact of Inventory Errors on Financial Statements

Errors in inventory valuation distort COGS, net income, and balance sheet.

Example: If Bhatbhateni overstated ending inventory by Rs. 10,000:

• COGS would be understated by Rs. 10,000 → Net Income increases by Rs. 10,000.
• Assets (Inventory) would be overstated by Rs. 10,000.

7. Real-World Applications in Nepal

A. Daraz (E-Commerce)

• Uses FIFO for perishable goods (e.g., groceries) to ensure old stock is sold first.
• Uses AVCO for non-perishable items (e.g., electronics) for smooth profit reporting.

B. NTC (Telecom Goods)

• Uses LIFO for bulk purchases of SIM cards (prices fluctuate; LIFO reduces taxable income).

C. Local Retail Shops (e.g., Kathmandu’s "New Road" Stores)

• Many use AVCO due to stable prices and simplicity in manual records.

D. Banks & Financial Institutions (e.g., NMB, Global IME)

• Use FIFO for documentary goods (e.g., chequebooks, passbooks) to match physical flow.

8. Worked Example: NEPSE-Listed Company (Example)

Company: Nepal Food Industries Ltd. (NFIL) Data for Baisakh 2080:

• Jan 1 (Baisakh 1): Beginning inventory = 2,000 units @ Rs. 50/unit
• Jan 15 (Baisakh 15): Purchased 3,000 units @ Rs. 60/unit
• Jan 20 (Baisakh 20): Sold 4,000 units @ Rs. 100/unit
• Jan 30 (Baisakh 30): Purchased 1,000 units @ Rs. 65/unit

Required: Calculate COGS and ending inventory using FIFO and LIFO.

Solution:

A. FIFO Method

1. Sell oldest stock first:
   • 2,000 units @ Rs. 50 = Rs. 100,000
   • Remaining 2,000 units @ Rs. 60 = Rs. 120,000
   • Total COGS = Rs. 220,000
2. Ending Inventory:
   • 1,000 units @ Rs. 60 + 1,000 units @ Rs. 65 = Rs. 125,000

B. LIFO Method

1. Sell newest stock first:
   • 1,000 units @ Rs. 65 = Rs. 65,000
   • 2,000 units @ Rs. 60 = Rs. 120,000
   • Remaining 1,000 units @ Rs. 50 = Rs. 50,000
   • Total COGS = Rs. 235,000
2. Ending Inventory:
   • 2,000 units @ Rs. 50 = Rs. 100,000

TABLE: NFIL’s COGS & Ending Inventory

Observation:

• LIFO shows lower profit (Rs. 165k vs. Rs. 180k) → Lower tax liability (useful for NFIL in inflationary periods).

9. Journal Entries for Inventory Transactions

Example: Bhatbhateni’s Purchase & Sale of Rice

A. Purchase of Inventory (Perpetual System)

Date       | Particulars                     | L.F. | Amount (Rs.) | Debit   | Credit
-----------|----------------------------------|------|--------------|---------|--------
Chaitra 10 | Purchases A/c Dr.                |      | 12,000       | 12,000  |
           | To Cash A/c                     |      | 12,000       |         | 12,000

B. Sale of Inventory (Perpetual System)

Date       | Particulars                     | L.F. | Amount (Rs.) | Debit   | Credit
-----------|----------------------------------|------|--------------|---------|--------
Chaitra 15 | Cash A/c Dr.                     |      | 24,000       | 24,000  |
           | To Sales A/c                    |      | 24,000       |         | 24,000
           | COGS A/c Dr.                    |      | 13,400       | 13,400  |
           | To Inventory A/c               |      | 13,400       |         | 13,400

Note:

• In periodic system, COGS is calculated only at year-end via a closing entry:

  Date       | Particulars                     | L.F. | Amount (Rs.) | Debit   | Credit
  -----------|----------------------------------|------|--------------|---------|--------
  Year-End   | COGS A/c Dr.                    |      | 13,400       | 13,400  |
            | To Inventory A/c               |      | 13,400       |         | 13,400
  

10. Exam Tip: How to Score Full Marks

✅ Understand the difference between FIFO, LIFO, and AVCO – Exam often asks for COGS calculation using all three methods. ✅ Show all steps clearly – Partial credit is given for correct intermediate steps. ✅ Label your tables properly – Use headers like "COGS Calculation" and "Ending Inventory." ✅ Mention the impact on financial statements – Always state how errors affect net income and assets. ✅ Use real-world examples – Relate to Nepali businesses (Daraz, NTC, local shops) for better understanding. ✅ Practice numerical problems – Most exam questions are numerical; solve at least 5-10 past papers.

Common Mistakes to Avoid: ❌ Forgetting to calculate ending inventory – Always find both COGS and ending inventory. ❌ Mixing up debit/credit in journal entries – Inventory is an asset (debit for purchases, credit for COGS). ❌ Ignoring the impact of inflation – LIFO is better in inflation; FIFO in deflation.

11. Quick Revision Summary

mindmap
  root((Inventory Valuation))
    Methods
      FIFO
        "Oldest sold first"
        "Higher profit in inflation"
      LIFO
        "Newest sold first"
        "Lower tax in inflation"
      AVCO
        "Average cost used"
        "Smooths profits"
    Systems
      Perpetual
        "Real-time updates"
        "Used by Daraz, Ncell"
      Periodic
        "Year-end adjustment"
        "Used by small shops"
    Errors
      Overstatement
        "Overstates profit"
      Understatement
        "Understates profit"
    Real-World
      Daraz: FIFO for groceries
      NTC: LIFO for SIMs
      NFIL: LIFO for tax benefits