Do you know how much your inventory is worth? And how do you know how much your inventory is worth? If your inventory is one of your business’ most valuable assets, it’s a real advantage to know not only the accurate value of your supply, but also to understand the way in which that value is determined. Let’s take a look at the mechanics of inventory accounting!
Inventory value doesn’t seem like a complex concept, and in some cases it isn’t. We can think of the total value of a business’s inventory as a function of the inventory at the start of the accounting period, inventory purchased or produced during the period, and the cost of the goods sold during the period. Both starting inventory, and inventory purchased or produced, are relatively straightforward ideas. If a business has constant costs of production, cost of goods sold is the same value. And where a business does not sell a consistent product (in that those products are homogenous or not usually interchangeable), then costs are assigned to goods sold by specifically identifying their individual costs of production. However, when a business’s costs are not specifically identifiable, and also change during an accounting period, the cost of the goods sold during an accounting period can be a little less simple to work out.
For example, if each and every ton of milk powder produced by a dairy company cost $1,000 to produce during a financial year, the cost of goods sold would be $1,000. However, let’s say that the price of raw milk goes up in the middle of the financial year and causes the costs of production to rise to $1,250. The cost that attaches to goods produced the first 6 months of the year is $1,000 per ton. However the cost that attaches to goods produced in the second 6 months is $1,250. The inventory is likely now a mix of $1,000 and $1,250 goods. Now let’s assume that the dairy company sells 75% of its total production in that year. What is that firm’s cost of goods sold, and how much is the remaining inventory worth? There’s no inherent answer to this question, which is why inventory valuation rules have been developed to prescribe a way of assigning the costs of production to the cost of goods sold.
There are three well-known methods of inventory valuation. In First-In, First-Out (FIFO) inventory valuation, the costs of the units that you added to your inventory first are moved from inventory to costs of goods sold – so your inventory value is a function of the production cost of the units added to inventory first. In Last-In, First-Out (LIFO) inventory valuation, the costs of the units that you most recently added to your inventory are moved from inventory to costs of goods sold – meaning that your inventory is valued on the basis of the units you added to your inventory last in the accounting period. And then there’s the Average Landed Cost (ALC), which is simply the total production cost of all the units available for sale divided by the number of units. A word of warning, however; not all countries’ accounting standards allow the use of Last-In, First-Out inventory valuation, so be sure to check what rules apply in your country if you’re considering using LIFO.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.