Final answer:
The double-extension method values inventory using both base-year and current-year prices. Price indices and inflation rates can be calculated using a base year value of 100, with subsequent years indicating price changes relative to the base year. The inflation rate is dependent on the selected base year and may differ when using different base years.
Step-by-step explanation:
In the double-extension method, the value of the inventory is extended at both base-year prices and current-year prices. The purpose of this method is to account for changes in price levels when valuing inventory. By comparing the extended values at base-year prices to those at current-year prices, one can determine the effect of inflation on the value of inventory held.
To calculate the inflation rate using index numbers, one would typically use a base year as a reference point. The price index for the base year is set to 100. For subsequent years, the index reflects the ratio of the current year's price to the base year's price, multiplied by 100. Therefore, index numbers can simplify the total quantity spent over a year for products and facilitate the calculation of inflation rates.
Applying this to a practical example, let's calculate price indices using the provided basket of goods prices over four years in the United Kingdom:
- For year 1 as the base year (set to 100), the indices would be: Year 1: 100, Year 2: £970/£940 × 100, Year 3: £1000/£940 × 100, Year 4: £1070/£940 × 100.
- For year 4 as the base year (also set to 100), the indices would be the inverse of Year 4 index from the first base year: Year 1: £940/£1070 × 100, Year 2: £970/£1070 × 100, etc.
The inflation rate based on the indices from the first base year is the percentage change in the index numbers. The inflation rate would be different using the second base year's indices because the percentage changes between indices would not be the same.