Inventory Valuation

Inventory is rightfully called the main and most important asset of any business. A balanced inventory management secures sales, profits, warehouse and logistics processes, customer orders fulfillment, and staff productivity. Overall retail business performance greatly depends on its ability to count, classify, and manage inventory.

Inventory valuation is a process of estimating the monetary value of the items found on the company’s balance sheet at the end of each financial period. Inventory valuation accuracy has a direct impact on a company’s financial statements and performance indicators.

Inventory Valuation

Methods of inventory valuation

There are different ways and methods that help companies to manage their inventory balance sheets. 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: definition, pros/cons and examples

First-In-First-Out (FIFO) method of inventory valuation is easy, accurate and quite logical: it is based on the assumption that the products which are purchased from the supplier (or produced) earlier are sold first. So, FIFO method takes the cost of the oldest inventory as a basis of COGS (Cost of Goods Sold) formula.

In retail, COGS is a main performance indicator, that calculates all the direct costs associated with your products sale (storage, shipping, customs clearance, store rental etc.) COGS does not include indirect expenses, such as marketing or advertising, staff salaries etc. The formula of COGS calculation is pretty simple: Cost of Goods Sold = Beginning Inventory + Direct Expenses – Ending Inventory. As a retailer you must always remember that the higher your COGS is, the less money you make

If a company uses FIFO as a primary inventory valuation method, it has to understand that the goods that arrived earlier from the supplier (or manufacturer) may sometimes be cheaper than the newer ones. It depends on the supplier pricing strategy, but usually the prices tend to rise rather than to fall. So, in this case, COGS will be lower, and profit figures will be higher. That will result in a higher base for taxation.

Except from being easy-to-manage and understandable, FIFO method helps retailers to cut waste and spoiled goods quantities, as you always sell the older inventory first. That is why FIFO method is so popular among businesses dealing with fast-spoiling goods, for example, fresh milk, vegetables, meat, eggs, fruits etc.

One of the biggest and most considerable disadvantages of FIFO inventory valuation method is a high level of dependance on prices. In case of inflation, the base of taxable income may rise dramatically and distort financial performance.

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: definition, pros/cons and examples

Last-In-Last-Out method is the opposite to FIFO. It assumes that the most recent products are sold first. Under LIFO method, the inventory that was acquired first, remains on the company’s balance sheet, while the newer items are being sold. LIFO method is used in the US, as it is acceptable under the GAAP regulations.

If a company uses LIFO as a reference inventory valuation method, it eventually has higher COGS, but lower profit and taxable income indicators. When a company uses Last-In-Last-Out inventory valuation method, the earnings and financial statements shown are lower and the taxable income is less. This may be good when time to pay taxes comes, but, from the other side, it may present the company as a less reliable contractor and lower the chances of getting investor or credit funding.

How to calculate inventory value using LIFO method?

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: definition, pros/cons and examples

WAC inventory valuation method stands for Weighted Average Cost. Under WAC method, a retailer estimates a weighted average by dividing the COGS by the number of items available. So, the retailer can then have the actual picture of inventory available on hand, an average between newest and oldest products.

WAC inventory valuation method is basic and simple, and is sometimes referred to as a starting point for retail business. WAC deals with simple similar items, that are easy to track. The calculations are easy and you do not have to invest time and money into sophisticated accounting and record tracking systems, or hire a lot of people.

On the contrary, if use WAC valuation, and your products belong to different price categories, you can lose money by taking the average price as a reference point and blurring the difference between expensive and cheap goods.

How to calculate inventory value using WAC method?

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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