We have many times discussed the importance of inventory management and its impact on a business’s future. But today we will speak about different methods of inventory valuation, about the main principles of choosing inventory valuation methods.
What is the inventory?
Inventory is the assets that a company has on hand. It is divided into 3 main types:
- Raw materials
- WIP items
- Finished goods
As the main goal of all businesses in the world is to get profit, it is necessary to accurately evaluate your company’s inventory and income.
In a short inventory valuation is the general value of inventory after a certain accounting period.
Inventory valuation methods
We will introduce you the following inventory valuation methods:
FIFO and LIFO are widely known terms in inventory manufacturing and retailing. Every company has to analyze its sales and learn how to calculate Cost of Goods Sold (COGS) at the end of any certain period. It will show you how your sold inventory has cost you and your current remaining inventory values. These metrics are too important for making accurate reporting.
FIFO stands for First In, First Out. The essence of the FIFO method of inventory valuation is that products are sold to their manufacturing. That is, the oldest products are sold first. Many companies use just this method for inventory valuation because it can maximally show the right flow of goods. Consequently, these costs are first to be involved in the balance sheet.
If you want to get a clearer image of FIFO, you should solve a simple calculation.
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 with different prices. 30 units/ $12, 70units/$13, 20units/$14. Moreover, at the end of the month, 105 units have already been sold. 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
That’s we consider that 5units are sold with a cost of $11, 30 units/ $12, 70units/$13, which means that the remaining 20units will be sold with a cost of $14 and the value will be $280.
Pros and Cons of FIFO
FIFO has four main advantages:
- Simple concept
- Saves money
- No risk of manipulation of income
- The balance sheet is approximate the present market value
- The flow of costs corresponds with the real flow of goods
FIFO has the following disadvantages:
- Higher Tax liabilities
- Not the best method in case of hyperinflation
LIFO stands for Last in, Last out. The LIFO method of inventory valuation calculates COGS according to the cost of inventory at the end of a certain period. The essence of this method is that no matter the item is made last, it is sold first. To tell the truth this method is not widely used because of being not realistic. Whether does it cost to keep inventory longer? Of course, not. It makes no sense.
As above let’s discuss an example to be clearer.
The company has a product in 20 units with a cost of $10. Later it purchases 30 units with a cost of $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:
Finally, there will remain 15 units/$15 and 20units/$10 value of $425 in general.
Pros and Cons of LIFO
LIFO has the following main advantages:
- Accurate measurement of current profit
- Lower Tax Liabilities
- No risk of future higher price affection
- The physical flow of inventory
The main disadvantages of LIFO are:
- Reduced profit
- Understatement of inventory
- The possibility to manipulate the income
Which inventory valuation method to 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 certain method every company chooses to value its inventory costs depends on the company location and of course own preferences. Surely, both methods assume inventory is sold in certain orders. However, FIFO is considered to be the most preferred and profitable method of COGS than LIFO as it shows the real state of your costs and profit.
In the end, we will advise all businessmen to be too attentive: “Every inventory valuation method will directly affect your profits“.