Inventory valuation refers to the accounting activity of attributing a monetary value to all the goods in a company’s inventory at the end of an accounting period. In simple terms, it means determining how much is the worth of all the goods in a company’s inventories. The final number resulting from the valuation includes all the costs incurred while purchasing or manufacturing.
The value of a company’s inventory appears on its balance sheet. For many businesses, inventories are their most significant asset, and their value plays a crucial part in the company’s ultimate profitability. Calculating the cost of goods sold and determining the company’s bottom line is impossible without first doing an inventory valuation. Once the value is specified, companies can also use their inventory as collateral for loans if it is of sufficient amount and not obsolete in any way.
The four widely accepted methods of inventory valuation are:
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Weighted Average Cost
- Specific Identification
First-In, First-Out (FIFO)
FIFO takes the first items to enter the inventory is also the first ones that sold. The unsold items in the inventory are value-matched to the most recently manufactured or purchased things. For example, let’s imagine a factory produces 1000 pairs of socks in January at the cost of $5 per pair and 1000 more pairs in February at $6 per pair. According to FIFO, if the company sells 1000 pairs in March, the cost of goods sold (COGS) on the income statement will be $5 per pair. January inventory was used because $5 was the cost of the pairs that first entered the inventory. The $6 pairs of socks will end up in the ending inventory.
FIFO is often used because it is simple and easily understandable. The FIFO method has a significant drawback during high inflation when it fails to depict costs accurately. When prices increase, FIFO will generate higher values of the ending inventory and a lower cost of goods sold. This results in a falsely higher gross profit in times of rapid inflation.
Last-In, First-Out (LIFO)
The assumption under LIFO is that the last units arriving into inventory will be the first ones sold. Old inventory remains. This method is used less often than FIFO since old inventory is harder to sell. The values from LIFO will result in lower company profitability. If we remember our imaginary sock manufacturing factory, with LIFO, the $5 sock pairs will constitute the ending inventory while the $6 pairs used to calculate COGS. LIFO does have tax advantages during inflation, as lower profitability means companies pay less tax.
Weighted Average Cost
This method takes the average value of all units ready for sale and, based on that, determines the value of the inventory and COGS. This method is most commonly used by businesses that manufacture or sell products that are difficult to track and are indistinguishable (bread, bolts, mortar, etc.)
This method is opposite of the Weighted average cost and is only used for high-value items (high-end machines, made-to-order industrial vehicles, etc.). The Specific identification method can not be put into practice unless every item is tracked individually with a serial number, an RFID tag, or other valid means.