Inventory refers to finished goods, work in progress and raw materials. It means those goods which are used in the production process of the company. It is considered as an asset. So there must be a clear method which is used to ascertain cost to the inventory to record it as an asset.
The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned.
Not always it happens that prices remain constant. It changes over the period so an organization ends up having the same type of goods with different prices. When an organization sells these, they have to decide at what prices they are going to sell these inventories. There are various methods to value inventory and they are:
a) FIFO- It refers to First in First out. It assumes that an organization must sell the items which are bought first, so the remaining items are the newest ones.
b) LIFO- It refers to last in First out. In this method, items which are bought last are sold first and remaining ones are the old items. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards.
c) Weighted Average Method