Stocks and How To Value Them
In this article we would briefly explain how to determine the purchase cost of stocks, the problems
associated in determining how they are valued, and the basic methods used to solve these problems.
The Purchase Cost of Stocks
Basically, when a company purchases stock from a creditor, whether by cash or on credit, the company
would gather the source documents, and enter the details in the books of prime entry. Thus, the cost paid
for each purchase is the purchase cost of stock, right?
Not necessarily, because first of all, the cost paid for each item purchased may differ during each
purchase, either due to discounts, sale, inflation, etc. In addition, imagine purchasing 100 items of stock
every month, and at each month the amount paid for each item differs slightly, how is it possible to
calculate which item was sold and how much money we made on each item?
Furthermore, imagine items being returned others being damaged or stolen. The process of thinking about
it is tedious enough imagine trying to record it!
NRV, Current Replacement Costs and the Selling Price of Stocks
Basically, before we proceed, Stock is valued at the lower of its net realizable value and its historical cost
value. The net realizable value is the expected selling price for each item of stock less any costs still to be
incurred in getting them ready for sale. The Current Replacement Cost is the amount it would cost to
replace each item of cost. Historical Cost is simply the cost at which they were originally bought.
The reason why stock is valued at the lower of the net realizable value and historical cost is due to the
prudence concept. The selling price is avoided because it would include a profit figure for the business
before the stock is even sold!
Furthermore, SSAP 9 encourages the use of two methods FIFO and AVCO, and discourages the use of
LIFO whilst valuing stock.
FIFO, AVCO and LIFO
FIFO stands for, First in, First Out, and it assumes that materials are issued out of stock in the order in
which they were delivered into stock. In other words, the first item supplied is the first item sold. Hence,
issues are priced at the cost of the earliest delivery remaining in stock.
LIFO stands for Last in, First Out, and it assumes that materials are issued out of stock in the reverse
order to which they were delivered. In other words most recent deliveries are issued before earlier ones,
and are priced accordingly.
AVCO stands for Cumulative Weighted Average Pricing, which calculates a weighted average price for
all units in stocks. This could be very helpful in determining the cost of consignment stock. Basically a
new weighted average price is calculated whenever a new delivery of materials into store is received.
Worked Example
Let us assume that the following transactions occurred, and we were to calculate what the value of the
closing stock based on the following valuation methods, FIFO, LIFO and AVCO.
Date
Receipts/Issues
01 May
03 May
04 May
09 May
11 May
18 May
20 May
31 May
Opening Balance
Receipts
Issues
Receipts
Issues
Receipts
Issues
Closing Balance
Qty of
Units
300
400
500
400
500
400
100
400
Unit
Cost
12.00
12.50
Total
Cost
3600
5000
14.00
5600
15.00
6000
Sale Price Per Unit
20
20
20
Well the table basically says that at the particular date we either had a receipt of goods into the company,
or we issued some goods. In other words receipts are purchases and issues are sales (I used the terms
receipts and issues as it was used in the BPP example). The number of units received or issued, their
corresponding unit price and their market value on the date of transaction are also presented.
The problem is to put a valuation on the issues of materials, and the closing stock, and how they would be
valued using FIFO, LIFO and Average Cost.
FIFO
First, we would rearrange the table in the following manner, entering and calculating the details as per the
requirements of each header. As you can see, whenever units are issued, we select the balance of the first
remaining units.
Date
Issues /
Receipts
Narrative
1/5
3/5
O. Bal
Receipts
300 @ 12.00
400 @ 12.50
4/5
Issues
300 @ 12.00
200 @ 12.50
9/5
Receipts
400 @ 14.00
11/5
Issues
200 @ 12.50
300 @ 14.00
18/5
Receipts
400 @ 15.00
20/5
31/5
Issues
C. Bal
100 @ 14.00
400 @ 15.00
Closing Stock
Value
3600
5000
8600
(3600)
(2500)
2500
5600
8100
(2500)
(4200)
1400
6000
7400
(1400)
6000
Balance of units
remaining
300 @ 12.00
300 @ 12.00
400 @ 12.50
200 @ 12.50
200 @ 12.50
400 @ 14.00
100 @ 14.00
100 @ 14.00
400 @ 15.00
400 @ 15.00
400 @ 15.00
LIFO
The process of calculating the closing stock value in terms of LIFO is very similar to FIFO except for a
major difference, in that whenever units are issued we select the pricing of the latest units received.
Date
Issues /
Receipts
Narrative
Closing Stock
Value
1/5
3/5
O. Bal
Receipts
300 @ 12.00
400 @ 12.50
4/5
Issues
400 @ 12.50
100 @ 12.00
9/5
Receipts
400 @ 14.00
11/5
Issues
400 @ 14.00
100 @ 12.00
18/5
Receipts
400 @ 15.00
20/5
31/5
Issues
C. Bal
100 @ 15.00
100 @ 12.00
300 @ 15.00
3600
5000
8600
(5000)
(1200)
2400
5600
8000
(5600)
(1200)
1200
6000
7200
(1500)
5700
Balance of units
remaining
300 @ 12.00
300 @ 12.00
400 @ 12.50
200 @ 12.50
200 @ 12.50
400 @ 14.00
100 @ 14.00
100 @ 14.00
400 @ 15.00
400 @ 15.00
100 @ 12.00
300 @ 15.00
AVCO
The process of using AVCO is slightly more complicated. A new cumulative weighted average cost per
unit is calculated whenever units are received/purchased/supplied. It is calculated by dividing the Closing
Stock Value by the total balance of units remaining. Furthermore, whenever items of stock are issued, the
cost per item is the cumulative weighted average cost calculated previously. This cost is also used to
calculate the new cumulative average cost whenever units are later received.
Date
Issues /
Receipts
Narrative
1/5
3/5
O. Bal
Receipts
300 @ 12.00
400 @ 12.50
4/5
Issues
500 @ 12.2860
9/5
Receipts
400 @ 14.00
11/5
Issues
500 @ 13.428
18/5
Receipts
400 @ 15.00
20/5
31/5
Issues
C. Bal
100 @ 14.686
400 @ 14.686
Closing
Stock Value
3600
5000
8600
(6143)
2457
5600
8057
(6714)
1343
6000
7343
(1469)
5874
Balance (Units)
300
400
700
(500)
200
400
600
(500)
100
400
500
(100)
400
New AVCO Unit
Price
12.00
12.286
13.428
14.686
14.686
Let us now take this example a little further, in order to realize how the closing stock figure affects the
cost of goods sold and the company’s gross profit.
Remember the sale price per unit in the table that includes the summary of the transactions above?
Well, each unit was uniformly sold for a price of $20, thus since total issues (sales) are 1000 units, the
figure for sales is $22,000.
To calculate the cost of sales (COGS), we need to obtain the values for opening stock, closing stock, and
purchases. The first two are already available. But what about purchases?
Well purchases is simply calculated, by adding up the value of each receipt. Now let us summarize all this
information, into the following profit and loss account:
Sales
Less Cost of Sales
Opening Stock
Purchases
Closing Stock
Gross Profit
FIFO
22,000
3600
16600
(6000)
(14200)
7800
LIFO
22,000
3600
16600
(5700)
(14500)
7500
AVCO
22,000
3600
16600
(5874)
(14326)
7674
Now, although these calculations may look difficult at first, practicing selected questions make them
seem really easier. Yet, in reality the calculations may actually be much more complicated and more
difficult to manage.
The next point that I would like to bring to your attention is how the gross profit differs when each
method is selected. Yet, the continuous use of each method, would mean that the profit differences are
only temporary, since the closing stock values would be the next period’s opening stock values, which
would affect the cost of sales and profits in the future so that the inequalities of the cost of sales each
month will even themselves out.