What is value? It can mean different things to different people and will represent something different to both you and your customers.
Consumers see value in the form of the benefit and functionality that a product offers. Value to the business represents the financial cost or revenue stream inventory creates. From an accounting perspective, the sole determination of inventory value is its profitability.
The two accounting practices for recording inventory transactions are the perpetual and periodic systems:
- The perpetual system updates inventory continuously each time a purchase is made from suppliers or a product is sold to a customer. Adjustments are made any time an item has been returned due to damage or defect or where cash discounts have been applied.
- Periodic inventory is a valuation method that relies on physical inventory counts undertaken at specific times. In the periodic inventory system, the cost of goods sold is not determined until the end of the accounting cycle.
Inventory is a current asset on the company balance sheet. As such, valuations need to be undertaken at the end of reporting periods to ensure these assets are accurately stated.
A ‘Rule of thumb’ approach to inventory valuation is to measure it at the market rate or what you paid. There are three main cost flow methods used to evaluate inventory. These are First In, First Out (FIFO), Last In, First Out (LIFO) and Weighted Average Cost. The physical flow of products does not have to match the accounting method chosen.
First in, first out
Under FIFO, the first units purchased are assumed to be sold first and the ending inventory is made up of the most recent purchases. Inventory is sold in the chronological order of acquisition with beginning inventory sold first, followed by purchases within the period.
In a periodic accounting system, inventory levels are checked at fixed intervals on a weekly, monthly or yearly basis. The first products purchased are assumed to be the first products sold.
Using this method, the oldest inventory costs are assigned as the cost of goods sold with the cost of recent inventory acquisitions remaining as ending inventory.
Last in, first out
Using LIFO, the most recent purchases are assumed to be sold first and the ending inventory is made up of the first units purchased.
The actual flow of inventory does not have to match the cost flow method used. For example, companies dealing in perishable goods may move inventory on a first in, first out basis to clear older stock even when using the LIFO cost flow method for accounting purposes.
It should be noted that the LIFO cost flow method is not permitted under New Zealand tax laws.
The weighted average method divides the cost of goods available for sale by the quantity of goods available for sale, resulting in the weighted-average cost per unit.
In this calculation, the cost of goods available for sale is the total beginning inventory plus additional purchases within the period. The weighted average uses the average unit cost to determine ending inventory and the cost of merchandise sold.
When the average cost is used in a perpetual system, an average unit cost for each item is computed each time a purchase is made. The unit cost is then used to determine the cost of each sale until another purchase is made and a new average is computed.
When considering which costing method to choose, it is important to consider how closely each method reflects the actual cost of inventory flow and how well costs are matched to related revenues.
Price fluctuations can change inventory value and inventory valuation directly affects the total current asset inventory represents, and the total asset balances of your business. The different valuation methods can result in different net values; therefore, businesses are required to select one valuation method and use it consistently over time.