Inventory Valuation

Counting the cost of inventory available on the shelves of a warehouse at the end of each accounting period is a primary thing each retailer is doing regularly.

Inventory is money. Evaluating the inventory is a basic integral part of business accounting, for both SMEs and large retail networks.

Inventory valuation is also needed to calculate the cost of goods sold (COGS), another important performance and accounting indicator in retail business. Be careful not to mix inventory value and the COGS!

Inventory valuation is a complex of operations and instruments that help you count the monetary cost of inventory which is lying on the shelves of your warehouse at the end of each period (a month, a quarter, a year).

Having accurate and exact data on the cost of sold, unsold, expired or damaged goods is crucial to have your balance sheet and business performance indicators up-to-date.

Inventory Valuation

Methods of inventory valuation

Basically, there are three most popular and widely-used methods of inventory valuation: 

  • FIFO (First-In-First-Out);
  • LIFO (Last-In-Last-Out);
  • WAC (Weighted Average Cost).

All these methods have their specific features, their pros and cons. 

How to choose inventory valuation method? 

The choice of method usually depends on the nature of goods and the region you are operating in. 

Accounting standards and principles vary - for example, businesses of the USA work under GAAP (Generally Accepted Accounting Principles), while the majority of other countries operate under IFRS (International Financial Reporting Standards). This is an important factor to consider, as the LIFO inventory valuation method is not accepted by the regulations of the IFRS. 

Another very important thing to remember - financial reporting allows the use of a single valuation method, so switching or combining them can not be possible.

First of all, consider the accounting standards and regulations accepted in your region. Second, consider the nature and type of your products. And remember, once you have chosen the method, you will not be able to choose another one or combine them. 

FIFO method

First-In-First-Out method of inventory valuations means that the first products which are purchased from the supplier (or produced) are sold first. 

This method is widely-used among businesses dealing with fast-spoiling goods, for example, fresh milk, vegetables, meat, eggs, fruits etc. 

How to calculate inventory value using FIFO method?

In January a village grocery purchased fresh milk - 

at first, 100 bottles of full-fat milk, 1$ per bottle
and then, 200 bottles of same full-fat milk from another manufacturer, 2$ per bottle.

By the end of January, 50 bottles of milk were sold.

So, using FIFO we calculate the cost of goods sold for the first batch of milk. We take the FIFO product price and multiply by the quantity of products sold. 

Cost of Goods Sold = 1$ x 50pc = 50$ 

We have another 50 bottles of milk on the shelves, and 200 bottles of full-fat milk from another manufacturer. Let’s calculate the inventory value:

Inventory value in January = (1$ x 50pc) + ( 2$ x 200pc) = 450$ 

LIFO method

Last-In-Last-Out method is the opposite to FIFO. It assumes that the latest products are sold first.

LIFO method is used in the US, as it is acceptable under the GAAP regulations. 

Let’s continue using a grocery store example, and let’s calculate the end of January’s inventory value using LIFO. 

Disclaimer:  this example is only used for illustration, as milk and dairy products can be spoiled, and therefore such products can not be stored for too long. Do not try this in real life. 

So, we take 200 bottles of full-fat milk we purchased later at the price of 2$ per bottle. 50 bottles were sold, as we know. 

So, using LIFO we calculate the cost of goods sold for the second batch of milk. 

Cost of Goods Sold = 2$ x 50 = 100$  

And the 100 bottles of milk purchased at the beginning of the months (1$ each) are still unsold. 150 bottles of milk (2$ each) are also unsold. So, let’s calculate the inventory value in January:

Inventory value = (1$ x 100) + (2$ x 150) = 400$ 

WAC method

Under Weighted Average Cost method we calculate simply the average cost of products sold. 

Let’s illustrate using the same example. All in all, grocery store bought 300 bottles of milk (100pc+200pc) and paid 500$ (100$ + 400$). 

Disclaimer:  this example is only used for illustration, as milk and dairy products can be spoiled, and therefore such products can not be stored for too long. Do not try this in real life. 

Here comes the weighted average cost. 

WAC = 500 / 300 = 1.66$ per bottle.

At the end of the month we have sold 50 bottles, so the COGC = 50pc x 1.66$ = 83$ 

Inventory value = 250 x 1.66 = 415$ 

Irrespective of the inventory valuation method chosen, real-time data record and accurate calculations is a must-have. Keeping detailed spreadsheets for each SKU can be ineffective especially for large retailers, owning dozens, hundreds and thousands of SKUs across several locations and sales outlets. We recommend using more sophisticated automated software which can accommodate any valuation method chosen and keep your calculations up-to-date and take care of all your business needs.

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