EVALUATION OF STOCK
INTRODUCTION
Organization purchase stock at significant costs and store that inventory at great
expense on the assumption that the utility derived will be greater than the total cost of
ownership. It is clear that the existence of obsolescent and redundant inventory as a
negative impact on the profitability of an organization and that every effort should be
made to avoid it.
This is more difficult in some operations than in others and the nature of some
products may render them more vulnerable to deterioration which in some industries
scrap may be caused as a consequence of the production process. Nevertheless, every
effort must be made to reduce redundant and
obsolescent items of stock.
VALUATION OF STOCK
The inventory valuation method a company chooses can affect its gross profit during
an accounting period. Note that the choice of inventory valuation method is an
accounting decision and not necessarily related to the way a company actually uses its
inventory.
Selecting an inventory valuation method is also important because once a company
has made its decision, it generally should stick to it. The IRS requires companies to
commit to one method during their first year of filing tax returns, and to obtain
permission if they want to change the method in subsequent years.
There are several methods for calculating inventory value.
1.The First In, First Out (FIFO) method values inventory as though the first
inventory items purchased are the first to be sold. For example, if a company uses
FIFO valuation, it is not obliged to move the oldest inventory first.
2.The Last in First Out (LIFO) method values inventory as though the Last
inventory items purchased are the first to be sold. inventory first.
3.The Weighted Average Cost (WAC) method is based on the average cost of items
purchased. The way a company values its inventory directly affects its cost of goods
sold (COGS), gross income and the monetary value of inventory remaining at the end
of each period. Therefore, inventory valuation affects the profitability of a company
and its potential value, as presented in its financial statements.
Objectives of Inventory Valuation
The overall objective of inventory valuation is to help create an accurate picture of a
company’s gross profitability and financial position.
Costs Included in Inventory Valuation
At the end of an accounting period, inventory exists in a finished and unfinished state.
How do you value that investment? To make a bicycle, you need parts. But you also
need someone to put the parts together, and you also incur a range of other overhead
costs. Inventory valuation accounts for all of those costs.
1. Direct labor. Companies spend a lot of money on labor, whether for salaried
employees or hourly workers. But not all of that labor is expended making the
products. Therefore, only the direct labor is included in inventory valuation. This
includes wages, the payroll taxes paid by the company, pension contributions and any
company-paid insurance coverage, such as medical, life and workers’ compensation.
2. Direct materials. Any materials and supplies used in manufacturing a product
count as direct materials. This includes supplies that are consumed or discarded in the
process, as well as any materials that are damaged and unusable. A good rule of
thumb is any cost that varies with each unit of manufacture is a direct cost.
3. Factory overhead. Factory overhead covers all expenses incurred during the
manufacturing process other than direct labor and direct materials. Examples include
the salaries of people who are involved in producing inventory but not actually
making the products, such as production supervisors, quality assurance professionals
and materials managers. Factory overhead also includes rent, utilities, insurance,
equipment setup and maintenance costs. It also includes the purchase cost of small
factory tools that are fully expensed when acquired, as well as the depreciation costs
of larger equipment.
4. Transport costs. This is the cost for the delivery of goods to the company. There is
a matching transportation cost if a company offers free or discounted shipping to its
customers and absorbs the associated costs.
5. Handling. This includes everything involved in preparing a finished product for
shipping: the labor involved in picking the inventory, packing it for shipment,
generating a shipping label and getting the
product onto a truck.
6. Import duties. This is the money payed a duty on any imported materials or
supplies used in producing its goods. Exceptions include items that are duty-free
thanks to trade agreements or for other reasons.
Dealing with scrap, obsolete and surplus materials
Terms like obsolete, obsolescent, redundant and scrap are usually interchangeably but
tis terms refer to different types of materials. Obsolescent stocks are stocks that are
expected to pass out of use at some point in the foreseeable future but are not
currently unusable.
Obsolete stocks are stocks of items that have passed through the state of
obsolescence and are of no continuing use to the organisation.
Scrap refers to items that are unusable. Scrap may be produced by product of a
production operation or through damage and deterioration.
Redundant stock is all usable material stocked in excess of requirement.
Surplus stock is the stock that a company holds in excess. It goes beyond the
amount that was needed to meet demand.
Drivers of Obsolete and Redundancy Stock
1. Inadequate forecasting methods.
2. Ignoring seasonality
3. A lack of market understanding
4. Product life cycle
Preventing obsolescent and redundant stock
Thorough planning Inventory forecast and management practice systems
Effects of Obsolescent and redundant stock
1. Storage costs
2. Tied-up cash
3. Product expiration
Ways to prevent overstocking of inventory
1. Invest in inventory management software
2. Assess economic and market trends (Google Trends)
3. Audit your inventory regularly (measure up to your key performance indicators KPl)
4. Use ABC analysis
