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To gauge a company’s profitability, it is vital to determine the value at which it records inventories in its final accounting statements. This is where inventory valuation comes into play. In this article, we will discuss inventory valuation, the significance of inventory valuation, inventory management, inventory valuation methods and their comparison, challenges existing in inventory valuation, and other related aspects.
What Is Inventory?
Inventory is the goods available for sale and the raw materials used to manufacture goods. It is a current asset recorded on a company’s balance sheet. In other words, an inventory is a comprehensive list of items like merchandise, property, goods in stock, and materials possessed by a business for sale to earn profit.
In any manufacturing business, the inventory is not merely the final product, factory-made and available for sale. It is also the raw materials used to manufacture and the semi-finished goods used in the warehouse.
What Is Inventory Valuation?
Inventory valuation is the monetary amount linked with goods held in inventory at the close of an accounting period. The valuation process depends on the costs sustained to procure the stock and make it available for sale. With the help of inventory valuation, a company can assess its Cost of Goods Sold (COGS), which helps it determine profitability.
Because inventory is the crucial asset of a company and is recorded on its balance sheet, inventory valuation is, too, an essential factor for that company’s accounting.
Why Is Inventory Valuation Important?
Inventory valuation is a method used to value closing inventory. At the end of the year, it is necessary to count inventory to reach the closing stock. But only counting inventory is not sufficient; it also needs to be valued. The inventory valuation process helps the company evaluate the value it will record the stocks in the last accounting statements. You can get an unbiased view of the company’s finances with precise inventory valuation.
Here are the reasons justifying the importance of inventory valuation:
Helps In Income Determination
A company must calculate the gross profit or loss incurred in a particular year to estimate the income. For that, it is necessary to match the cost of goods sold with the direct revenue of an accounting period.
With the following formula, a company can calculate the cost of goods sold (COGS) to help determine its income.
COGS = Opening Inventory + Direct Expenses + Purchases – Closing Inventory
Helps In Determining The Financial Position
Inventories are referred to as current assets of any company. They are not merely components of the profit and loss statement but also included in a company’s balance sheet. Hence, it is vital to have accurate inventory valuation. If the calculated inventory value is incorrect, it will signify an inaccurate financial position on the specific date of the balance sheet.
When it comes to stock, there are plenty of turnovers. Inventory is a significant component of the working capital of a firm. So, it is inevitable to value inventory precisely to ensure the liquidity and current ratios can be calculated exactly. These ratios help determine the liquidity of a company.
Helps Determine A Company’s Profitability
How a company values its inventory influences its gross income, cost of goods sold (COGS), and the financial value of stock left at the termination of every period. Thus, inventory valuation directly influences a company’s profitability and potential value (denoted in its financial statements).
Influences On Cost Of Goods Sold
If the valuation for ending inventory is higher, less expenditure will be charged to the cost of goods sold (COGS) and vice versa. Therefore, inventory valuation prominently influences reported profit levels.
Issues With Inventory
Any business must be familiar with possible issues they may face with the inventory. These include:
Excess inventory leads to additional costs to the firm in storage prices and funds stuck in unused stock. If companies don’t use inventories rapidly after purchase, their business begins facing the loss of money spent on the materials. If any of the materials come out defective, it can take a long time for the company to detect the problem.
An inventory system should collect quantitative information and provide details of its locality in the building. Misplaced inventory leads to a waste of time because workers look after lost materials. Furthermore, time delays can lead to delayed deliveries to customers.
Varying Demand Of Customers
The demand of customers is constantly varying. Keeping it too much can lead to obsolete inventory that a company can’t sell. On the other hand, holding it too little cannot accomplish customer orders. There are ways to resolve these issues and meet the varying demands of customers. These include formulating order strategies for essential items and implementing technology to design and work on an inventory plan.
Lack Of Skilled Inventory Management
Finding expert inventory managers proficient in cutting-edge technology and competent in enhancing inventory strategy can be challenging. Merely upgrading the inventory management platform with the latest features is not adequate. Proficient inventory management is required.
Inventory Management And Valuing Your Inventory
Inventory management tracks inventory directly from producers to warehouses and from these services to the point of sale. Inventory management’s objective is to ensure the right products are available in the right place and at the right time. Inventory visibility is required for this. It implies determining the time and quantity to order and the location to store stock.
Inventory management entails these fundamental steps:
The goods ready to sell are bought and delivered to a specific point of sale or warehouse.
Until the need arises, inventory is stored. Goods are moved through your fulfillment network until they are ready for delivery.
Gaining Profit From Inventory
Valuing Your Inventory:
The general principle to value inventory is that it must be valued at the amount you paid for it and its market value. Except the merchandise is obsolete, it is typically valued at cost.
The question now arises, what’s the cost? It can be the first or last price being paid or the average price. Moreover, there are speculations on what’s included in the cost i.e., labor, overhead, and consignment, or merely the cost of purchases.
The way you value inventory decides the costs of sales and profit. Its formula is as below:
Costs of sales = Inventory purchases + Beginning inventory – Ending inventory
Essentially, ending inventory relies on the way you value inventory on the balance sheet. If the inventory is lower, the cost of sales is higher, and so profit is lower. On the other hand, a higher inventory valuation leads to lower sales costs and more profits.
Why it’s important to maintain healthy inventory levels
The two key objectives of inventory valuation are:
Inventory valuation can accurately determine income by matching reasonable costs with revenues.
Gross profit = Cost of Sales – Cost of goods sold
Here, the Cost of goods sold = Purchases + Opening stock – Closing stock
Financial Position Determination
The inventory held at the close of an accounting period should be represented as a current asset on the balance sheet. If the merchandise is not correctly valued, then the balance sheet will not reveal the accurate financial position of the particular business.
Inventory Valuation Methods
Let’s check out the meaning of three primary inventory valuation methods:
The FIFO method is the most convenient and extensively used method for valuing inventory. This method undertakes that the first product sold by a business is from the oldest set of goods it purchased. Accordingly, it values the inventory. Moreover, the FIFO method can closely match the exact inventory costs.
Generally, the oldest set of goods is cheaper than the ones that follow. This is because the prices of materials and other inventory costs will likely increase over time owing to inflation. Therefore, FIFO typically leads to a higher gross income and lower COGS than other valuation methods.
The LIFO method is based on the assumption that the recent inventory is sold first. This method offers a more accurate matching of expenditure with revenue. Moreover, it lowers the tax bill and increases the COGS of the company. However, it usually features an obsolete number on the balance sheet and can retain the cost of goods purchased previously in the inventory account for several years.
As the name implies, this method employs an average of every inventory cost. This method is commonly used when inventory items are indistinguishable. Moreover, it could streamline inventory costing since it averts the requirement to track the price of special inventory purchases while calculating tax liability and profit. WAC also benefits in reducing fluctuations in profit owing to the duration of purchases and sales.
Comparing Different Inventory Valuation Methods: FIFO, LIFO, And WAC
Comparing these three inventory valuation methods is vital to deciding which one to adopt.
The FIFO method aims to generate the highest gross income throughout the current period, the LIFO method generates the lowest, and WAC is somewhere in between. All these methods presume a characteristic inflationary environment wherein the cost of supplies usually increases over time. As a result, the FIFO method produces the highest taxes, LIFO generates the lowest, and WAC generates in the middle.
Each of these methods comes with unique advantages. Several companies adopt the FIFO method that matches the sale price to the inventory cost. But it can lead to higher taxes and gross income.
The LIFO method matches current expenses to current revenue. However, it is not accepted under accounting rules in several countries.
WAC method can streamline accounting.
Selecting the appropriate inventory valuation method for the business relies on various factors like your business location, how much its inventory fluctuates, and whether your costs increase or decrease.
Challenges of Inventory Valuation
Inventory valuation faces two challenges discussed here:
The company should evaluate the total cost of its inventory. This requires finding out the amount of stock being held, which can be challenging.
The fundamental formula to calculate the value of a business’ remaining inventory (at the end of the accounting period) derives from the formula of COGS. It is as below:
COGS = Purchases + Beginning inventory – Ending inventory
Ending Inventory = Purchases + Beginning inventory – COGS
Note that it may not be easy to calculate the beginning and ending inventory values. Those goods you can’t sell at the total price (because of destruction while delivery, uselessness, or modifications in consumer preferences) should be depreciated and valued accordingly.
Calculating The Amount Of Inventory
This task can be more challenging than it appears. For instance, a company transports goods and decides whether to include those items in the inventory. Furthermore, it might have to carry out t physical inventory counts.
Several companies calculate inventory through a periodic inventory system. This system assesses inventory at the close of an accounting period. An alternate method is a perpetual inventory system that tracks sales and purchase orders. Moreover, it constantly updates inventory to represent those transactions.
Inventory valuation is commonly carried out at the end of the fiscal year to compute the cost of sold and unsold goods. It is inevitable because the excess or shortage of inventory can influence the profitability, product, and also success of the company.
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The four inventory valuation methods are:
- Specific identification
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
The two most common methods of inventory valuation are FIFO and LIFO.
FIFO (first-in, first-out) method assumes that goods are sold in the order they are purchased. It is an easy method for costing, which is extensively used.
LIFO (last-in, first-out) assumes that the newest stock is sold first. This method decreases the income tax affliction on the business. Moreover, it ensures that the company doesn’t face lower profitability.
Stock valuation is the process of finding out the theoretical value of a stock. Five methods of stock valuation are listed below:
- Dividend Discount Model (DDM)
- Discounted Cash Flow Model (DCF)
- Comparable Companies Analysis
- Asset-based Valuation Method
- Some of the Parts Valuation Method
When the matter comes to the selection of methods for inventory valuation, most businesses adopt the FIFO method. It is easy to use and presents the most precise value of profitability and cost. In addition to being easy to comprehend and easy to manage, it assists retailers in controlling spoiled and waste goods. This is because it always prioritizes selling the oldest inventory first.
In the majority of cases, businesses assume the inventory as an asset. The reason is the aspect on which the business spends money and its value. If it is being used by the company or sold as part of business conduits, they can consider it as an inventory. A company’s inventory can entail parts or segments of materials and products. Moreover, it also entails the finished products before shipping to sales and production items for sale.