On a period-by-period basis you are likely to use the system facilities to record cost of sales and to give you gross margin figures (sale value less cost of goods) by the analysis categories you need — product group, customer, salesperson, and so on. This gross margin is effectively calculated for each transaction, and is very dependent, therefore, on the cost value recorded for each stock item.
At the end of the year you will do a physical stock count, and the value of your stock is then determined by the product of the physical stock counted and the cost price recorded for each item. At this level, gross margin is determined by taking the opening stock valuation for the year, adding the cost of all stock purchased during the year, and then deducting the year-end stock valuation. This does not depend on the quantities recorded in the stock system, and so takes care of errors such as stock being issued without it being recorded, and the perpetual problem of pilferage.
There is a danger that if you put too high a valuation on your stock, then you will show too high a profit for the year, whereas if you value your stock too low, you will undervalue the trading strength of your company. Stock valuation again depends very much on the cost value recorded for each item.
Notes
If you have not encountered this issue before, it is worth trying out a few examples to show how overvaluing the closing stock can increase dramatically the company profit figure and vice versa. For example:
Valuation 1 Valuation 2 Valuation 3
Sales 850,000 850,000 850,000
Opening Stock 180,000 180,000 180,000
PLUS Purchases 510,000 510,000 510,000
LESS Closing Stock 170,000 140,000 200,000
Cost of Sales 520,000 550,000 490,000
Gross Margin 330,000 300,000 360,000
Overheads 300,000 300,000 300,000
Profit/Loss 30,000 nil 60,000
A swing of less than 20% in closing stock valuation either wipes out the profit entirely, or doubles it!
The accountant’s definition of the cost price to use in stock valuation is "the lowest of actual cost price or net realisable value”. In many cases you may not know the actual cost price because you’ve bought several batches, all at different prices, and you can’t tell from which batch your current stock came.
The standard ways to maintain the cost price of your stock items are:
LIFO.This is an acronym of Last-In-First-Out.It assumes that the cost price to use is the cost price of the most recent batch. This is likely to overvalue your stock (under the accountant’s definition) if prices are rising, and therefore report a higher profit. It gives, however, the replacement value for your stock, which could be argued to be the most practical valuation. If prices are generally falling (as in the computer industry, for example) it effectively devalues your stock as prices fall, and so records a lower profit that the strict accountant’s definition would give; this can be argued as the conservative option in this case.
FIFO.This is an acronym for First-In-First-Out. To manage FIFO requires additional fields to hold the quantities of each batch of goods as they are received, so that stock is allocated from the oldest batch first.Whilst it satisfies the accountant’s definition (assuming you can still sell at greater than cost) you can argue that it doesn’t represent the replacement value. If prices are falling, it is best not to use FIFO costing because it can overstate the common-sense view of gross margin. See further comments on FIFO later.
Average Cost. This is the most widely used option, because it steers clear of the pitfalls of LIFO, and gives a similar valuation to FIFO without the additional work which FIFO causes.Each time stock is received, the cost value is recalculated using the formula:
(Old Physical Quantity x Cost Price) + (Purchase Quantity x Purchase Price)
_____________________________________________________________
(Old Physical Quantity + Purchased Quantity)
The costing options are defined for your stock system under the stock System Profiles though note that both purchase order processing, bill of materials and invoicer all have separate controls for updating the cost price.
Notes
As well as the cost price, a stock system option maintains a field for "Last Order Price”. If defined, it is this field which is offered as the stock item price in purchase order processing.
Article ID: 401
Created On: Mon, Jun 18, 2012 at 10:30 AM
Last Updated On: Thu, Jun 22, 2023 at 11:30 PM
Online URL: https://kb.datafile.co.uk/article/stock-valuation-and-cost-prices-401.html