Small and medium businesses looking to optimize their inventory management need to understand the importance of correct inventory valuation. How a business chooses to determine its inventory value has a direct impact on its financial reporting – most notably the profit and loss statement, income statement and balance sheet.
Selecting the right inventory valuation method for your business will largely depend on the nature of your business as well as the type of inventory it sells. A business that deals in goods that are subject to continuous fluctuations in value, are perishable, or lose value relatively quickly over time should adopt an inventory valuation method that reflects these characteristics.
Similarly, a business that deals in inventory that maintains a relatively stable value over time, and is therefore largely resistant to sudden spikes and dips in value, would ensure their inventory management system operated off a valuation method that was aligned with this type of inventory.
Why determining inventory value is important to get right
How a business opts to calculate its inventory value is very important. Inventory management software can be programmed to calculate inventory value using a number of key formulas. However, the one that is chosen will impact a business in several key ways. These include affecting the cost of goods sold, gross profit, as well as the net income on a company’s income statement. It will also affect the total of current assets, working capital, total assets and equity as represented on the balance sheet.
Calculating inventory value
The way inventory value is most typically calculated is by taking the inventory a business starts the year with, adding the purchases throughout the year and then subtracting the inventory sold through the year. The amount that is left over is the inventory value. The formula for this is depicted below:
Starting Inventory + Net inventory purchases – COGS (Cost of Goods Sold) = Ending inventory
The COGS is simply the sum of all costs that go into the production of a product for sale. COGS includes the cost of raw materials, parts and labor but not any expenses such as sales or distribution costs.
The simplest way to calculate COGS is to take starting inventory, add purchases for the period and then subtract ending inventory. While there are more complex and detailed methods to calculate COGS, this is the simplest and easiest.
Now that we have a broad overview of what inventory value is and how it is calculated, we can delve deeper and examine the three most common ways to calculate inventory value and how each one impacts the business.
What are the 3 most important inventory valuation methods?
First in First Out – FIFO
This inventory valuation method calculates inventory based off the assumption that the first item brought into inventory is the first to be sold. To illustrate FIFO more succinctly let’s look at the following example:
Joe’s Doughnuts produces 100 doughnuts a day over the weekend for sale on Monday morning. On Saturday the cost to produce each doughnut was $1.00 whilst on Sunday the cost rose to $1.50 due to having to pay higher labor costs for staff working on a Sunday. On Monday the shop sells 100 doughnuts.
If Joe’s Doughnuts uses FIFO to calculate its inventory value, it will record the COGS as $1.00 each and it will be recorded as such on the income statement. This valuation method assumes that the first doughnuts to be made (Saturday’s batch) were also the first to be sold off to customers. The remaining 100 doughnuts, which cost $1.50 each to make would be recorded to ending inventory on the balance sheet. This leaves Joe’s Doughnuts with a stated inventory value of $150.
Utilizing FIFO typically results in higher gross and net profits being reported. This is in large part due to the nature of rising costs over time due to inflation. When a business records lower COGS, its bottom line can appear inflated. From a shareholder’s perspective, this can be viewed as a benefit. However, a higher net profit means the business inevitably has to pay more in taxes. In some situations, when the COGS rise substantially over a period of time, the business could be put on a bad footing.
Last in First Out – LIFO
LIFO is the exact opposite of FIFO. This inventory valuation method operates under the assumption that the last items taken into inventory are the first to be sold off. In keeping with the example of Joe’s Doughnuts above, we find that the COGS recorded to the income statement will be recorded at $1.50 each as opposed to $1.00 each.
The ending inventory value on the balance sheet will then be recorded as $100, and due to the higher COGS, the Net Profit will be lower. While this means the business appears to be not as profitable, it also means the business pays lower income taxes and records a higher inventory asset value in the balance sheet.
LIFO when utilized in inventory management leaves the business vulnerable to inaccurate inventory values. This is because it allows for the possibility that the remaining inventory is extremely old and possibly obsolete and therefore a liability, since it is unsellable and must be written off.
Weighted Average Cost – WAC
Perhaps the most balanced inventory valuation method is the Weighted Average Cost method. As the name implies, this accounting method calculates the COGS and ending inventory value by taking the weighted average of all inventory items available for sale during the period.
Utilizing the example of Joe’s Doughnuts above, the WAC of inventory can be calculated as follows:
(100 x $1.00) + (100 x $1.50) / 200 = WAC $1.25 each
Ramifications of incorrectly calculating inventory values
A key aspect of effective inventory management is being able to select and apply the best inventory valuation method for your business. Financial operations can be conducted with total accuracy, ensuring that all inventory is 100% accounted for in real-time, through the use of a powerful inventory management software.
Failing to correctly value inventory, either through choosing the wrong inventory valuation method or a lack of vital inventory management software, can have significant consequences for the business on multiple fronts.
Income statements will reflect incorrect balances, which can lead to a range of issues when it comes to financial planning, including paying inflated income taxes, ordering in surplus inventory or running into shortages. All of these issues place a considerable burden on the bottom line and foster further operational and financial inefficiencies down the road.
On the other hand, when a suitable inventory valuation method is adopted and inventory control is efficient and effective, the business is able to operate proactively and profitably by aligning its supply chain operations with accurate financial systems and methodologies.