Inventory valuation is the practice of assigning value to unsold inventory for the purposes of end of year financial reporting. There are different inventory valuation methods which deliver different results in terms of profits, tax liability and company valuation, so it’s important that the right inventory valuation method is chosen. This is especially true given the large proportion of financial outlay that inventory makes up for many companies.
Inventory valuation also affects key operating metrics such as COGS and Gross Profit Margin. Any business that holds inventory needs to choose a single inventory valuation method – and apply it consistently.
Key Outtakes:
- The inventory valuation method chosen affects reported profits, company valuation & tax
- Accurate inventory valuation is important for operational clarity and decision-making
- Not all methods are legal in all countries
- Automated inventory systems will update and record correct inventory values in real time
Inventory valuation methods
There are three main inventory valuation methods in inventory accounting, known as LIFO, FIFO and Weighted Average Cost. Unleashed inventory software for example, values inventory according to the Weighted Average Cost method.
The difference between LIFO, FIFO and Weighted Average Cost
LIFO, FIFO and Weighted Average Cost are the three most used inventory valuation methods employed by businesses to gauge their inventory levels accurately and assess the overall state of health of their operations.
Apart from the effect on a business’s balance sheet, income statement, and cash flow statement, choosing the right inventory costing method will also offer the most accurate snapshot of inventory levels. Having a clear and detailed appreciation of inventory levels will allow a business to proactively manage its inventory and foster enhanced efficiency and profitability.
FIFO: First-In, First-Out
FIFO inventory cost-valuation works off the assumption that the first inventory bought is also the first inventory to be sold. So let us look at an example to illustrate how FIFO works.
A business that sells baseball caps begins with a starting inventory of 50 caps valued at $1 each ($50), and through the course of the financial year orders 50 more units at $2 each. The business’s sales for the year equal a total of 40 caps at a sales price of $5 per cap. The business’s expenses for the year amounts to $50.
Using the FIFO method here is what we can expect to see reflected on the company’s income statement:
Beginning inventory = $50 (50 units @ $1ea)
Purchases = $100 (50 units @$2ea)
Sales = $200 (40 units @ $5ea)
Expenses = $50
According to FIFO – First-In, First-Out – the Cost of Goods Sold (COGS) is calculated off the cost of the oldest inventory in stock. In this case then, the COGS amounts to $40 – 40 units x (beginning inventory value of $1ea).
The Ending inventory value then, is the value of whatever inventory the business has left. In this case, that would be 10 units at $1 each (from the beginning inventory) and 50 units at $2 each (from purchases). This leaves the business with an ending inventory value of $110.
Gross profit = $160 (Sales – COGS)
Net Profit = $110 (Gross Profit – Expenses)
FIFO provides a better value on inventory when conducting final inventory calculations because it assumes that original inventory is sold first, dropping the Cost of Goods Sold against the sales price, as well as minimizing the risk of longer-stored inventory going obsolete.
While this is advantageous to the bottom line in one respect – higher net income and therefore improved cash flow – it carries the disadvantage of higher taxes due to a higher Net Profit.
Generally, businesses that deal in fast moving inventory, or inventory with a short shelf life such as perishables, favor the FIFO inventory cost evaluation method – whereas those looking to capitalize on lower tax payments prefer the next inventory valuation method:
LIFO: Last-in, First-Out
LIFO assumes that the most recent – or last ordered in – inventory is the first to be sold off. Using the same example as above we can gain a clearer picture of how LIFO works to contribute to a lower tax burden by lowering the Net Profit of a business, by raising the Cost of Goods Sold against Sales.
Beginning inventory = $50 (50 units @ $1ea)
Purchases = $100 (50 units @$2ea)
Sales = $200 (40 units @ $5ea)
Expenses = $50
According to LIFO – Last-In, First-Out – the Cost of Goods Sold (COGS) is calculated off the cost price of the most recently purchased inventory. In this case then, the COGS amounts to $80 – 40 units x (most recent purchases at $2ea).
The Ending inventory value then, is the value of whatever inventory the business has left. In this case, that would be 10 units at $2each (from recently purchased inventory), and 50 units at $1 each (from beginning inventory). This leaves the business with an ending inventory value of $70.
Gross profit = $120 (Sales – COGS)
Net Profit = $70 (Gross Profit – Expenses)
LIFO contributes to a higher Cost of Goods Sold and therefore a lower Gross and Net Profit value. The immediate advantage to a business lies in not having to pay a higher tax on profits (as with FIFO).
However, from an inventory value perspective, LIFO is not considered to be a good value for final inventory calculation because it lowers the overall value of inventory on stock, and implies that companies hold on to their old inventory for longer. This places inventory at increased risk due to theft, damage and obsolescence.
Where is LIFO permitted?
It's important to note that while LIFO is allowed in the United States, it is prohibited in jurisdictions that use the International Financial Reporting Standards (IFRS).
Weighted Average Cost Method
When using the Weighted Average Cost method, a business calculates the average cost of its inventory over time and applies that to each sale. The Weighted Average Cost method can best be understood as a value neutral method, because it does not prioritise inventory based off either a FIFO or LIFO approach.
For most small businesses, this is the most popular inventory valuation method simply because it is the most balanced. It does not carry the associated risk of over-inflating or underestimating a company’s Net profit or inventory value.
Looking to the cap example for the sake of comparison here is what we find:
Beginning inventory = $50 (50 units @ $1ea)
Purchases = $100 (50 units @$2ea)
Sales = $200 (40 units @ $5ea)
Expenses = $50
First we need to find the average cost per unit by taking the total inventory cost and dividing that by the total number of units:
$150 (Beginning inventory plus purchases) / 100 (Total number of units)
= $1.50 (Average Cost)
From this we can calculate the Cost of Goods Sold (COGS) and the End inventory value
Cost of Goods Sold =$60 (Units sold x Average cost)
End Inventory = $90 (Unsold inventory x Average cost)
The Gross Profit and Net Profit based off the Average Cost method for this cap retailer then looks like this:
Gross profit = $140 (Sales – COGS)
Net Profit = $90(Gross Profit – Expenses)
While a simple example has been used here to convey the basic principles of the three inventory valuation methods and how they affect a business in different ways, the reality is that for most businesses inventory management is a very complex challenge.
This is why, apart from carefully evaluating the risks and benefits a FIFO, LIFO or Weighted Average Cost method will bring to your business, we advise that you invest in a powerful inventory management software system such as Unleashed to help you ensure that your inventory levels are accurate and under complete control.
