For the individual costing methodology, please refer to my article in BasicCollegeAccounting.com.

This article seeks to explore the most appropriate method of costing stock.

Why is it so crucial to choose the correct method?

Simply speaking, different methods used for valuing the SAME quantity of stocks will give different stock figures. As the closing stock figure is taken into account in arriving at the cost of sales, the accounting profit calculated is therefore highly dependent on the method of stock valuation used.

Briefly, let’s compare the different methods used:

First In, First Out (FIFO)

This method provides the lowest cost of goods sold during periods of rising prices and the highest cost of goods sold during period of declining prices. FIFO is therefore not suitable where prices are not stable as using this stock valuation will cause big fluctuations in profitability.

Last In, First Out (LIFO)

Conversely, this method provides the highest cost of goods sold during periods of rising prices. It disadvantage is that the stock figure in the Balance Sheet does not represent current market value. Hence, this method is not recommended by the accounting profession and the Inland Revenue.

The Average Method

It has the effect of smoothening out distortions in profit figure in period of fluctuating prices. It is a suitable method for manufacturing based business.

The Base Stock Method

This is not acceptable by the Inland Revenue as the original price may be very much below current prices during period of rising prices. This therefore would understate profit.

Standard Cost Method

which is acceptable on the proviso that the standard costs are reasonably accurate and occasionally being updated. If set up properly, the standard costs approximate actual costs. As the same prices will be charged to production and for valuation of stocks,profit figures should be most realistic compared to other methods.

Nevertheless, it is important to note that as each stock valuation method has different impact, we need to consider carefully which is the most appropriate method that suits the nature of the business .

In the same industry, the norm is to use the same type of stock method.

It can also be recommended by the external auditors.

Worst off, as stock method affects accounting profit, it can be manipulated by senior management to achieve their ambitious profit target so as to receive the incentives from their Board of Director

Or, it depends on the risk attitude of the management hence taking the more prudent method like average cost (weighted) or FIFO

Whatever method being chosen, it is vital, so to say, to follow the consistency concept. The enterprise must be consistent in its approach otherwise any changes in stock method must be disclosed.

If you found this post useful, keep updated with future posts by subscribing to FMAccounting (for free) through RSS or email.

Related Entries

• Inventory- Introduction
• Brand valuation – Basic Valuation Approaches
• Using Days Inventory Outstanding (DIO) for Better Stock Management
• Valuation Of Securities : Other Factors That Needs To Be Consider
• Variable/Marginal Cost Plus Pricing(Part3)