Methods of determining cost price of stocks
The term “Cost Price” has been interpreted in many ways, which are as follows:
1. Unit Cost Method: Under unit cost method, cost of unsold stock will be the actual price at which the lot to which it belongs purchased. If the goods purchased in different lots have been kept separately, the cost of unsold stock can be easily determined.
2. Average Cost Method: The principle underlying the average cost method is that the identity of different lots of goods is lost when they received in store. Oil stored in large tanks can be cited as an example here. In such a case, goods in stock are valued at the average cost price of various consignments taken together.
3. First-in-First Out (FIFO) Method: The basic assumption under this method is that the goods received first are sold or issued at first. In other words, the goods are issued in the order in which they were purchased. As the goods entered at first are issued at first and the most recent purchases remain in stock at the rate of the latest consignment so purchased. Hence, under this method, stock is valued at the rate at which the most recent purchases were made.
4. Last-in-First Out (LIFO) Method: This method is based on the assumption that the goods received at last are sold at first and the unsold stock consists of the earliest purchases and is priced accordingly. In other words, under LIFO method, the stock is valued at the rate at which the earliest purchases were made. However, this method is not much in use for the purpose of valuation.
5. Base Stock Method: Under this method, a certain minimum quantity of stock is always carried at the original cost and it is not supposed to be issued unless there is an emergency. This is treated as fixed asset. Materials, which are in excess of base stock, are issued by adopting either FIFO or LIFO principle. The base stock is deemed to have been created out of the first consignment and therefore valued at this price.
6. Highest-In-First-Out (HIFO) Method: The HIFO method assumes that the closing stock of materials should always remain at the minimum value, so that issues are priced at the highest value of available consignments in the store. Hence, it understates the value of stock and thus leads to the creation of secret reserves. This method is not popular.
7. Standard Cost Method: Under this method, the stock is valued at some predetermined price fixed on the basis of a specification of all the factors affecting the price.
8. Adjusted Selling Price Method: Under this method, an estimated cost is found out by pricing the unsold stock at the prevailing selling price less a normal margin of profits plus the estimated selling expenses including overhead charges.
From the above discussion it is clear that there are so many methods to determine the cost price of the stock. Now the question before us is which method to choose? Our answer to the question is — “It is the average cost method”. However, the cost is to be adjusted by adding all the direct expenses incurred on the purchase of goods.