Inventory Valuation & Cost of Goods Sold (Methods, FIFO, LIFO, Weighted Avg)

TAKEAWAYS

• Inventory valuation determines the cost of unsold goods, directly impacting COGS and profitability (higher COGS = lower profit).
• FIFO (First-In-First-Out) assumes the oldest inventory is sold first; LIFO (Last-In-First-Out) assumes the newest is sold first; Weighted Average uses the average cost of all inventory.
• Nepali businesses (e.g., Daraz, NTC, local grocery stores) use these methods to manage taxes, cash flow, and financial reporting under Nepali GAAP.
• Inflationary periods favor LIFO (lower taxable profit), while deflationary periods favor FIFO (higher reported profit).
• Perpetual vs. Periodic Inventory Systems: Perpetual updates records continuously (used by Daraz/Khalti), while Periodic updates only at year-end (common in small shops).
• Mismatch between physical stock and accounting records can lead to fraud or errors—always reconcile inventory counts.

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1. Why Inventory Valuation Matters

Inventory is a current asset that represents unsold goods. Its valuation affects:

• Cost of Goods Sold (COGS): Directly impacts gross profit and taxable income.
• Balance Sheet: Inventory appears as an asset; over/under-valuation distorts financial health.
• Decision-Making: Helps businesses set pricing, reorder points, and discount strategies.

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2. Key Definitions

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3. Inventory Valuation Methods

Three primary methods determine COGS and ending inventory:

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

• Assumption: Oldest inventory is sold first.
• Formula:

  COGS = (Units Sold × Cost of Oldest Layers)
  Ending Inventory = Cost of Newest Layers
  

• When to Use: Inflationary economies (e.g., Nepal’s rising fuel/food prices). Matches physical flow in many industries (e.g., perishables like vegetables).

Worked Example: Kathmandu Grocery Store

Transactions in Baishak:

• Sold 80 kg on 10 Baishak (all from 1 Baishak batch).
• Sold 40 kg on 20 Baishak (remaining 50 kg from 1 Baishak + 40 kg from 15 Baishak).

Calculations:

1. COGS (80 kg):
   • 80 kg × Rs. 150 = Rs. 12,000 (all from 1 Baishak).
2. COGS (40 kg):
   • 50 kg left from 1 Baishak: 50 × Rs. 150 = Rs. 7,500
   • 40 kg from 15 Baishak: 40 × Rs. 160 = Rs. 6,400
   • Total COGS = Rs. 7,500 + Rs. 6,400 = Rs. 13,900
3. Ending Inventory (30 kg):
   • Remaining 10 kg from 15 Baishak: 10 × Rs. 160 = Rs. 1,600

T-Account for Inventory:

Mermaid Diagram: FIFO Flow

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

• Assumption: Newest inventory is sold first.
• Formula:

  COGS = (Units Sold × Cost of Newest Layers)
  Ending Inventory = Cost of Oldest Layers
  

• When to Use: High inflation (e.g., Nepal’s recent price surges). Reduces taxable income (lower COGS = higher profit).

Same Example Revisited (LIFO):

1. COGS (80 kg):
   • 50 kg from 15 Baishak: 50 × Rs. 160 = Rs. 8,000
   • 30 kg from 1 Baishak: 30 × Rs. 150 = Rs. 4,500
   • Total COGS = Rs. 12,500
2. COGS (40 kg):
   • Remaining 20 kg from 1 Baishak: 20 × Rs. 150 = Rs. 3,000
3. Ending Inventory (20 kg):
   • All from 1 Baishak: 20 × Rs. 150 = Rs. 3,000

Comparison Table: FIFO vs. LIFO

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4. Weighted Average Method

• Assumption: All inventory has the same average cost.
• Formula:

  Avg. Cost = Total Cost of Inventory / Total Units
  COGS = Units Sold × Avg. Cost
  

Same Example (Weighted Average):

1. Avg. Cost = Rs. 23,000 / 150 kg = Rs. 153.33/kg
2. COGS (120 kg sold) = 120 × Rs. 153.33 = Rs. 18,400
3. Ending Inventory (30 kg) = 30 × Rs. 153.33 = Rs. 4,600

T-Account for Weighted Average:

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5. Perpetual vs. Periodic Inventory Systems

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6. Real-World Applications in Nepal

A. Daraz (E-Commerce)

• Method Used: FIFO for most products (e.g., electronics, groceries).
• Why?:
  • Matches physical flow (old stock shipped first).
  • Reduces obsolescence risk (e.g., old phone models).
• Impact: Accurate COGS helps Daraz set dynamic pricing and discounts.

B. NTC (Telecom Infrastructure)

• Method Used: LIFO for spare parts (e.g., cables, batteries).
• Why?:
  • High inflation in import costs (e.g., Chinese electronics).
  • Lower taxable profit (higher COGS reduces reported income).
• Impact: Better cash flow management for large purchases.

C. Local Grocery Stores (e.g., Kathmandu’s Thapathali Market)

• Method Used: Weighted Average (simpler for small businesses).
• Why?:
  • No automation; manual counting at year-end.
  • Avoids complex FIFO/LIFO tracking.
• Risk: Stockouts or overstocking if not managed carefully.

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7. Common Errors and Reconciliation

Mismatches between book inventory and physical stock can occur due to:

• Theft (e.g., employee fraud in small shops).
• Damaged/Obsolete Goods (e.g., expired medicines in pharmacies).
• Data Entry Errors (e.g., wrong quantities in Daraz’s system).

Solution: Physical Inventory Count at least once a year (or quarterly for large businesses).

Journal Entry for Shrinkage (Theft/Loss):

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8. Exam Tip: How to Score Full Marks

1. Always Show Workings:

   • Examiners require step-by-step calculations (e.g., FIFO layers, LIFO reversals).
   • Example: If asked to compute COGS under FIFO, list purchases in order and allocate sales accordingly.

2. Compare Methods:

   • Questions often ask: "Which method would you recommend for [scenario]?"
   • Answer template:

     "For [inflationary/deflationary] conditions, [FIFO/LIFO] is better because [reason]. For [small/large] businesses, [Weighted Average/Perpetual] is more practical because [reason]."

3. Real-World Links:

   • Tie answers to Nepali businesses (e.g., "Like Daraz, a grocery store should use FIFO to match physical flow").
   • Mention tax implications (e.g., "LIFO reduces taxable income during inflation").

4. Common Pitfalls:

   • Forgetting to adjust for partial layers in FIFO/LIFO.
   • Miscounting units in ending inventory.
   • Ignoring the periodic vs. perpetual distinction in multi-part questions.

5. Diagrams Save Marks:

   • Draw T-accounts for inventory adjustments.
   • Use flowcharts to show FIFO/LIFO layers (like the Mermaid example above).

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9. Practice Question (Worked Solution)

Question: Mr. Ram’s shop has the following transactions in Baishak 2080:

• 1 Baishak: Purchased 100 kg rice at Rs. 140/kg.
• 15 Baishak: Purchased 50 kg rice at Rs. 150/kg.
• Sold 120 kg on 20 Baishak at Rs. 180/kg. Calculate COGS and ending inventory using:

1. FIFO
2. LIFO
3. Weighted Average

Solution:

1. FIFO

• COGS:
  • 100 kg (from 1 Baishak) × Rs. 140 = Rs. 14,000
  • 20 kg (remaining from 1 Baishak) + 50 kg (from 15 Baishak) = 70 kg But since only 120 kg sold, and 100 kg already allocated, only 20 kg from 15 Baishak batch are used. Correction: Actually, after selling 100 kg from 1 Baishak, remaining 20 kg sold come from 15 Baishak.
    • 20 kg × Rs. 150 = Rs. 3,000
    • Total COGS = Rs. 14,000 + Rs. 3,000 = Rs. 17,000
• Ending Inventory:
  • 30 kg remaining (from 15 Baishak) × Rs. 150 = Rs. 4,500

2. LIFO

• COGS:
  • 50 kg (from 15 Baishak) × Rs. 150 = Rs. 7,500
  • 70 kg (remaining from 1 Baishak) × Rs. 140 = Rs. 9,800
  • Total COGS = Rs. 7,500 + Rs. 9,800 = Rs. 17,300
• Ending Inventory:
  • 30 kg (from 1 Baishak) × Rs. 140 = Rs. 4,200

3. Weighted Average

• Avg. Cost = (100 × 140 + 50 × 150) / 150 = (14,000 + 7,500) / 150 = Rs. 143.33/kg
• COGS = 120 × Rs. 143.33 = Rs. 17,200
• Ending Inventory = 30 × Rs. 143.33 = Rs. 4,300

Summary Table:

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10. Final Checklist for Exams

Before submitting: ✅ Label all methods clearly (FIFO/LIFO/Average). ✅ Show calculations step-by-step (no skipping layers). ✅ Reconcile totals (COGS + Ending Inventory = Total Cost). ✅ Link to real-world examples (e.g., "Like NTC, businesses in inflation use LIFO"). ✅ Draw diagrams if asked (T-accounts, flowcharts).

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