Inventory is rightfully considered the most significant and crucial asset for many companies. It is of critical importance both from operational and accounting perspectives. One of the primary accounting tasks when it comes to inventory is the valuation of the inventory worth.
What is inventory valuation?
A company assesses the monetary worth of the goods left in its warehouse and balance sheet at the end of each financial period. That process is called inventory valuation. Because it impacts financial statements and performance analysis, it is essential to ensure accuracy and consistency in inventory valuation.
Inventory valuation is used for profit maximization and is vital for the accuracy of inventory balances on financial statements.
Why is inventory valuation important?
Balance sheets and income statements
At the end of each financial year, companies prepare financial statements. Inventory is one of the main assets, so it is crucial to state it correctly to ensure the reports’ completeness. From the accounting perspective, inventory valuation impacts the balance of the cost of goods sold and assets. Inventory and costs associated with it also affect the net income.
Purchasing decisions
Companies should continuously evaluate inventory to know the profits and losses associated with it.
Stock purchasing is one of the main challenges in the inventory management processes. To increase the profitability, you should assess whether it is required to restock inventory or if the existing volumes are enough to meet your demands.
Budgeting
Inventory valuation results are used in budgeting decisions as well. When you estimate the worth of your inventory, you get a clearer idea of how much you can afford to spend on inventory purchases to stay profitable. It would also influence your choice of a manufacturer or vendor.
Understanding main valuation models
Your financial statements will be impacted by the inventory valuation method that you choose. The U.S. GAAP, which are the generally accepted accounting principles, suggests three inventory valuation models that businesses are allowed to use. Those include first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted-average method.
First-In, First-Out (FIFO)
It is not surprising that FIFO is the most popular inventory valuation method. It is a straightforward and logical model to understand and put into practice. The idea behind the first-in, first-out (FIFO) method, as the name suggests, is that the stock that enters the warehouse first should be the first one to leave it. In other words, the oldest inventory should be sold first.
Inventory valuation with FIFO: Example
Let’s assume that Company XYZ made the following inventory purchases:
July: 100 units; $10 each
August: 100 units; $12 each
September: 100 units; $15 each
By the end of the year, it sold 150 units.
Using the FIFO method, let’s find out the year-end inventory value that should be stated in the balance sheet.
So, because the model suggests the oldest inventory is sold first, the items sold were purchased in July (100 units) and August (50 units). As a result, at the end of the year, there will be 50 units left from the August purchases and 100 units from the inventory purchased in September. The year-end inventory value is the following:
50 x $12 + 100 x $15 = $2,100.
Benefits of the FIFO method
FIFO ensures many benefits. Firstly, by selling the oldest items first, the companies end up with the most current stock on hand. As a result, the inventory costs are in line with the current market rates and present a more accurate image of inventory value and replacement expenses. Another benefit is that you reduce the probability of getting your stock obsolete or perished by selling the oldest goods first. Moreover, when you sell the newest inventory last, the chances are higher to have inventory costs in line with inflation. The costs of a more recent stock better represent current market values.
Last-In, First-Out (LIFO)
The Last-in, First-out (LIFO) method assumes that the stock purchased last is sold first. So, the year-end inventory is valued at the cost of the oldest items. Because there are strong obsolescence and perishment risks associated with this model, it is less popular and practical. It does not provide an accurate value because yesterday’s costs might differ from today’s prices.
Inventory valuation with LIFO: Example
Let’s again take the data from the previous example.
Assume that Company XYZ made the following inventory purchases:
July: 100 units; $10 each
August: 100 units; $12 each
September: 100 units; $15 each
By the end of the year, it sold 150 units.
Let’s see the value of the inventory at the end of the year if the business uses LIFO model. So, in this case, the units sold were purchased in August and September. As a result, the inventory balance represents 50 units from August and 100 units from July. The total value will be the following:
100 x $10 + 50 x $12 = $1600.
Benefits of the LIFO method
The possible benefit that the LIFO model can provide refers to tax calculation. In the cases of high inflation, inventory sold has higher COGS. As a result of the high cost of goods sold, the income is lower, so is the income tax.
Weighted Average Cost Model (WAC)
The weighted average cost model takes the average cost of all units to determine the year-end inventory balance. This method is mainly helpful when stock units intertwin, and it is hard or impossible to identify the costs of each individual item. Usually, those items are identical, and companies sell them simultaneously.
Inventory valuation with WAC model: Example
Going back to the earlier scenario, let’s find out the value of period-end inventory.
Following were inventory purchases:
July: 100 units; $10 each
August: 100 units; $12 each
September: 100 units; $15 each
By the end of the year, it sold 150 units.
Step 1. Calculate average cost
Average unit cost = (100 x $10 + 100 x $12 + 100 x $15) / 300 = $12.33
Step 2.
150 units were sold, and 150 units are left. The inventory balance will be 150 x $12.33 = $1,849.5
Benefits of WAC model
The primary advantage of this method is consistency. The costs are calculated and used for all units. Compared to alternative methods, it also is simpler to calculate. There is less paperwork in this case. You should calculate one cost and apply it to all items and calculations.
Conclusion
Each model has its advantages. You should appropriately analyze all methods to choose the one that best suits your business. However, regardless of which inventory valuation method you choose, accurate calculations and timely data are crucial.
