Inventory is one of the most important assets an eCommerce company has. It represents the products or materials that a company has available to sell to customers. As such, it is critical for owners, investors, and managers to understand how retailers count the inventory value on the balance sheet. There are two main inventory valuation methods: FIFO and LIFO. So, how do you assess your inventory? Let’s discover the best practices together!
Key Points
- The First-In, First-Out (FIFO) refers to the inventory valuation method where the inventory purchased or manufactured first is assumed to be sold first
- The Last-In, First-Out (LIFO) refers to the inventory valuation method where the inventory purchased or manufactured last is assumed to be sold first
- The main difference between FIFO and LIFO inventory valuation methods is the order in which a company sells the inventory
Inventory Defined
Inventory is one of the most critical assets an eCommerce company has. Companies lacking inventory will have nothing to sell customers, generating no revenue. In fact, inventory represents the goods and raw materials, including finished products awaiting customer sale.
While speaking of inventory, we mean goods falling into four categories:
- Raw materials
- Work-in-progress (WIP)
- Finished goods
- Maintenance, repair, and operating (MRO)
Each category represents inventory at a different stage of the production process.
Case Study
For example, let’s imagine that you are an online retailer selling t-shirts. The inventory for your company would likely include:
- Raw materials – thread, fabric, and other supplies needed to make a t-shirt
- Work-in-progress – t-shirts that are in the process of being made
- Finished goods – completed t-shirts that are ready to be sold to customers
- MRO inventory – items like sewing machines or office supplies needed to run your business
As you can see, inventory can be physical goods or materials, but it can also be intangible items like patents or copyrights.
Why Does Inventory Valuation Matter?
As making a profit is the primary goal of any business, it is necessary to evaluate your company’s inventory and income accurately. Inventory valuation methods focus on the value of inventory on the balance sheet. While a balance sheet represents a business’s assets, liabilities, and owner’s equity on a specific date, inventory valuation methods help assess those assets’ value.
The value of inventory can have a significant impact on a company’s financial statements. For example, if a company has an inventory that is valued too high, it could result in an overstatement of profits. On the other hand, if inventory is valued too low, it could result in an understatement of profits.
Inventory valuation is also essential for tax purposes. Thus, the inventory value will be used to calculate the amount of taxes a company owes.
Different inventory valuation methods can result in additional tax liabilities. Thus, choosing one that suits your business’s needs and goals is crucial to ensuring accurate financial reporting.
Types of Inventory Valuation Methods
We will introduce you to the following inventory valuation methods:
- FIFO
- LIFO
FIFO and LIFO are widely known terms in inventory manufacturing and retailing. Every company has to analyze its sales and learn how to calculate the Cost of Goods Sold (COGS) through the balance sheets at the end of any particular period. It will show you how your sold inventory has cost you and your current remaining inventory values. These metrics are too crucial for making accurate reporting.
What Is FIFO, and How to Calculate It?
The essence of the FIFO method of inventory valuation is that products are sold to their manufacturing. That is, retailers sell the oldest products first. Many companies use this method for inventory valuation because it can show the correct flow of goods. Consequently, these costs should be on the balance sheet.
FIFO Example
You should solve a simple calculation to get a clearer image of FIFO.
Imagine there is a company selling a product in 5 units on hand with a cost of $11 per unit. Later the company purchased 120 units, too but at different prices. 30 units/ $12, 70units/$13, 20units/$14. Moreover, 105 units had already been sold at the end of the month. As a result, the company has only 20 units on hand. With the FIFO cost flow assumption, the first costs become the cost of finished goods.
Amount Price Paid
5 Units $11
30 Units $12
70 Units $13
20 Units $14
Cost of Goods Sold (COGS) Formula:
COGS=(5*$11)+(30*$12)+(70*$13)=$1325
Thus, we consider that 5 units are sold at $11, 30 units/ $12, and 70 units / $13, which means that the remaining 20 units will cost $14, and the value will be $280.
Pros and Cons of FIFO
Pros
- It is simple to use and easy to understand
- The method matches inventory costs with revenue from sales providing a more accurate picture of a company’s profitability
- Even beginners can quickly implement the FIFO method
- It is the most common inventory valuation method
- The flow of costs corresponds with the actual flow of goods
Cons
- Sometimes, FIFO can result in high tax liabilities
- In case inventory prices are rising, FIFO will result in lower reported profits
- It can be challenging to implement if a company has a complex inventory system
What Is LIFO, and How to Calculate It?
The LIFO inventory valuation method is just the opposite of FIFO. The LIFO inventory valuation method calculates COGS according to the inventory cost at the end of a specific period. The essence of this method is that no matter whether the item came last, retailers sell it first. To tell the truth, this method is not popular because it may seem unreal to implement.
LIFO Example
Still, as above, let’s discuss a LIFO example to be more explicit.
The company has a product in 20 units with a cost of $10. Later it purchases 30 units at $15. So it sells 15 units from the last purchased units.
Amount Price Paid
20 Units $10
30 Units $15
Cost of Goods Sold Formula:
COGS=15*$15=$225
Finally, 15 units/$15 and 20units/$10 value of $425, in general, will remain.
Pros and Cons of LIFO
Pros
- It is easy to understand and simple to implement
- The inventory cost always matches the revenue from sales, providing an accurate picture of a company’s profitability
- No risks of future higher price affections
Cons
- In case inventory prices are rising, LIFO will result in lower reported profits
- It is easier to manipulate the income with a LIFO report
- The inventory cost doesn’t always match the actual flow of goods
Which Inventory Valuation Method Should You Use?
Realizing the importance of inventory valuation, we have tried to introduce you to the essence of FIFO and LIFO and the main difference between them. Although we have spoken about the advantages of both methods, the specific method every company chooses to value its inventory costs depends on the company’s location and, of course, its own preferences. Undoubtedly, both methods assume selling inventory in certain orders. However, FIFO is a more preferred and profitable method of COGS than LIFO as it shows the real state of your costs and profit.
Whatever method you choose, note that eSwap always covers you in inventory management and valuation processes. The platform provides inventory management solutions with everything you need to streamline inventory management, including inventory valuation. So you can focus on your business goals and leave inventory management to the professionals!
