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Inventory constitutes everything that goes into making the finished products that a company manufactures or sells. It is one of the largest and most important current assets a business has, with a significant impact on its profitability. Also, inventory cost is one of the biggest expenses, making inventory valuation critical for financial reporting.
Inventory value gives an idea of the costs associated with goods sold and helps determine the worth of unsold merchandise lying in storage.
There’s more to inventory valuation and how it’s done. This article will walk you through everything you need to know and understand to calculate inventory value for your business.
What is Inventory Value?
In the simplest terms, inventory value is the cost associated with a business’s inventory. The value is based on the costs involved in purchasing the inventory and getting it ready for sale.
Inventory refers to all the raw materials and supplies a business acquires to sell to consumers or use in production/manufacturing directly. For instance, a confectioner would consider inputs such as sugar, flour, chocolate, or flavoring agents as the raw material inventory and freshly made candies or pastries as sales inventory awaiting purchase from consumers.
Regardless of your business, inventory holding is generally costly and often requires storage space facilities to accommodate high inventory levels. In addition, some types of inventories tend to lose value over time, particularly in industries prone to the constant change in market demands.
Inventory is an essential item in a company’s balance sheet. Thus, it is imperative to calculate the financial value associated with the inventory and also account for the unsold inventory when preparing financial statements.
Inventory Valuation Explained
Let’s get into a more detailed explanation of inventory valuation.
Inventory valuation is an accounting practice companies follow to determine the value of unsold stocks while preparing financial statements. While there is no universal approach to calculating inventory valuation, the general rule of thumb is that it should reflect the monetary value of your inventory stock on your balance sheet.
Every business has current assets; these are liquid assets with a short-term life and are listed on the left side of a balance sheet. A company’s inventory constitutes the least liquid current asset since it does not convert to cash until you find buyers for the inventory.
Since inventory is an asset, business owners must value their inventory to determine how much their inventory is worth at the end of every accounting period. An accounting period is typically a quarter or a year and varies from business to business. A company’s approach to value its inventory directly impacts its gross income, the cost of goods sold (COGS), and the value of inventory left at the end of each accounting period. Therefore, inventory valuation impacts a company’s potential value and profitability as reelected in its financial statements.
What are the Objectives of Inventory Valuation?
Companies typically carry out inventory valuation at the end of a fiscal year or an accounting period to ascertain the cost of unsold inventory and the cost of goods sold.
Valuation of inventory is crucial since a stock shortage or excess affects a company’s production and profitability. As such, the primary purpose of inventory valuation is to determine the actual income and financial position.
The core objectives of inventory valuation are:
Ascertaining A Company’s Gross Income
A company calculates its gross profit by deducting the cost of goods sold (COGS) from the net sales. COGS is the direct cost a business bears to sell goods, including raw materials and labor costs. It does not include indirect expenses related to distribution and marketing. The basic formula for COGS is:
COGS = (Inventory at the start of the accounting period) + (Purchases during the accounting period) – (Inventory at the end of the accounting period)
The above formula shows that the value of inventory affects the cost of goods sold and thereby, the company’s gross profit.
Determining A Company’s Financial Position
Inventory valuation directly affects a company’s gross profit and income statement and gives a clear picture of its financial performance. Closing stock or inventory is a current asset in a company’s balance sheet and determines the business’s financial position. As a result, overvaluation or undervaluation of the inventory at the end of the accounting period (ending stock) can give an inaccurate representation of the company’s working capital and overall financial position.
Costs Included in Inventory Valuation
Inventory valuation accounts for all the costs involved in the manufacturing/selling of a product, from raw materials and labor to transportation for delivery of goods to the retailer or consumer.
Here’s a breakdown of the costs included in inventory valuation:
Types of Inventory Valuation
The inventory valuation method you use depends on how you track your stocks over time. It will also impact the cost of goods sold (COGS).
There are broadly four inventory valuation methods you can choose from to ascertain your inventory value at the end of an accounting period. These are as follows:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
- Weighted average cost
- Specific identification
Let’s understand each method in detail.
First-In, First-Out (FIFO)
The basis of the first-in, first-out (FIFO) inventory valuation method is that the earliest manufactured or purchased inventory is sold first.
First-in goods are usually cheaper than newer acquisitions since the material and other inventory costs generally rise over time due to inflation. Thus, the FIFO approach results in a lower cost of goods sold and a higher gross income. Although the FIFO method most closely matches actual inventory costs, it has downsides. First, a higher gross income means hefty tax bills. In addition, FIFO can present a misleading picture of a company’s financial performance during inflation.
Last-In, First-Out (LIFO)
The last-in, first-out (LIFO) inventory valuation is based on the premise that older inventory remains in stock while newer merchandise is sold first.
However, this method is rarely used by companies because older inventory gradually loses value, generally remains unsold and results in significant losses for the company. Therefore, LIFO does not provide reliable inventory value since the valuation is lower than the actual market price of the inventory. However, a business can use LIFO if it expects the inventory cost to increase over time and result in inflation. Plus, considering recent, high-cost merchandise to value COGS lowers the reported profit, allowing businesses to pay less tax.
Weighted Average Cost
The weighted average cost (WAC) method considers the average of all inventory costs to determine the cost of goods sold and inventory. It is a relatively simple approach to inventory accounting because it eliminates the need to track separate inventory purchase costs while calculating profit and tax liability. Moreover, the weighted average cost method prevents the extreme cost of one or more purchases from affecting the cost of goods sold.
The specific identification method tracks every item in the inventory from purchase to sale. Thus, the method works best for inventory comprising large, easily identifiable items with widely different features and costs. However, the method requires that you track individual items with an RFID tag. The specific ID attached to items gives the most accurate record of the actual inventory cost and profit. Although the specific identification method imparts a high degree of accuracy to the inventory valuation process, it is broadly restricted to valuing rare and high-value items such as classic cars, precious jewels, and real estate.
Accounting for Inventory Value: How do you calculate inventory value?
1. First-In, First-Out (FIFO)
The FIFO method assumes that earlier purchased items are the first to leave the warehouse.
Say a company ‘ABC’ sells custom-designed smartphone covers. Below are the details of its purchases during the year:
Since FIFO assumes that the oldest inventory is sold first, the 300 covers bought in October are sold plus the first 100 purchased in November, giving a total of 400 items sold.
Thus, the inventory value under FIFO = (Units of newest stock x purchase value) + (units of any remaining stock x purchase value)
Plugging in the values we get,
Inventory value under FIFO = (100 x $5) + (100 x $4) = $900
Also, the cost of goods sold (COGS) = (number of items sold first x purchase value) + (Number of items sold next x purchase value)
Putting the values we get,
COGS = (300 x $3) + (100 x $4) = $1300
2. Last-In, First-Out (LIFO)
The LIFO method assumes that the newest inventory is sold first.
Following the previous example, the company sells 400 of the 600 covers it purchased. So, the 100 items it purchased in December, the 200 items it purchased in November, and another 100 items from October are sold. If 400 items were sold, 200 from October are still in the inventory.
Inventory value under LIFO = Oldest and remaining units of inventory x Purchase value
Putting the values we get,
Inventory value under LIFO = 200 x $3 = $600
Likewise, COGS = (number of items sold first x purchase value) + (Number of items sold next x purchase value)
Substituting the values we get,
COGS = (100 x $5) + (200 x $4) + (100 x $3) = $1600
3. Weighted Average Cost
The weighted average cost method finds the average of all inventory items purchased over the accounting period. Its formula is as follows:
Weighted Average Cost = COGS/Total number of units available over a period
Using the earlier example, let’s say the company has sold 400 out of 600 covers and values its inventory using the LIFO method. So, the COGS value is $1300, and we divide it by the total units (600) to get the weighted average cost.
Therefore, weighted average cost = $1300/600 units = $2.2
Choosing the Right Inventory Valuation Method
There is no one-size-fits-all approach to choosing an inventory valuation method for your business. Your inventory valuation approach will depend on the financial goals of your business and the market conditions. Each method has its benefits and limitations, and you need to focus on the changes in inventory costs to determine the best valuation method for you.
Below we summarize the suitability of each inventory valuation method to help you make the best choice:
- The LIFO method may be your best call if inventory costs are rising or are likely to shoot up. It results in higher COGS and lower profits.
- On the contrary, falling inventory costs call for the FIFO approach. It results in lower COGS and higher gross income.
- The weighted average cost method produces a gross income between those resulting from LIFO and FIFO.
- Use the specific identification method when you need to know the cost and selling price of every unit in your inventory. The method is ideal if you deal in rare or high-value items.
Why is Inventory Valuation Important for Businesses?
Different inventory valuation methods yield different outcomes, making a significant difference in the company’s balance sheet. Also, the COGS value under LIFO is significantly higher than under FIFO, giving a higher profit margin in the latter.
Inventory valuation is important for businesses for several reasons.
- Helps determine a company’s gross income and monetary value of end inventory
- Reflects a company’s financial position
- Helps understand the cash flow in a business
- Essential for figuring out the liquidity of a business
- Results in significant benefits in terms of tax cuts
Types of Inventory Valuation
Despite the benefits, inventory valuation has its set of challenges. The two primary hurdles in the process are:
- To determine the total inventory cost, companies must figure out how much inventory they have. It can be a complicated affair, especially for businesses with a large inventory and high SKU count.
- Calculating the value of the starting and ending inventories may not be as simple considering factors such as damage, changing customer preferences, or products becoming obsolete and unsellable.
Inventory is a current asset on a company’s balance sheet, and inventory valuation is a vital aspect of any business regardless of size or scope. A company’s inventory valuation method makes a remarkable difference in its financial statements and reflects its overall financial position. This article covers the fundamentals of inventory valuation, including the different methods to calculate inventory value. As a business owner, you must analyze each method and apply that which suits your business needs and accurately reflects your periodic income.
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Inventory value is the cost associated with a company’s inventory. The value is based on the costs involved in manufacturing or purchasing the inventory products and getting them ready for sale.
Companies selling physical goods must determine their inventory value for accounting purposes. Inventory accounts for a significant portion of business expenses, and its valuation impacts the company’s asset value, profits, and tax liability.
The objectives of inventory valuation are to determine a company’s gross income and overall financial position.
Inventory is valued at cost, not selling price. The inventory cost is the cost involved in purchasing items from a manufacturer or supplier plus any other expenses to get the items to the retailer or customer.
Weighted average cost, first-in, first-out (FIFO), last-in, first-out (LIFO), and special identification are the three broad inventory valuation methods. Each method has its benefits and limitations, and the best method for you depends on the market conditions and your business’s financial goals.