Inventory Valuation, Inventory Estimation Methods

Inventory valuation is the monetary amount associated with the goods in the inventory at the end of an accounting period. The valuation is based on the costs incurred to acquire the inventory and get it ready for sale. Inventories are the largest current business assets. Inventory valuation allows you to evaluate your Cost of Goods Sold (COGS) and, ultimately, your profitability. The most widely used methods for valuation are FIFO (first-in, first-out), LIFO (last-in, first-out) and WAC (weighted average cost).

Inventory refers to the goods meant for sale or unsold goods. In manufacturing, it includes raw materials, semi-finished and finished goods. Inventory valuation is done at the end of every financial year to calculate the cost of goods sold and the cost of the unsold inventory. This is crucial as the excess or shortage of inventory affects the production and profitability of a business.

Inventory is used to find the gross profit, which is the excess of sales over cost of goods sold. To determine the gross profit or the trading profit, the cost of goods sold is matched with the revenue of the accounting period.

Cost of goods sold = Opening stock + Purchases – Closing stock.

The above equation shows that the inventory value affects the cost and thereby the gross profit. For example, if the closing stock is overvalued, it will inflate the current year’s profit and reduce profits for subsequent years.

Specific Identification

Under this method, every item in your inventory is tracked from the time it is stocked to when it is sold. It is usually used for large items that can be easily identified and have widely different features and costs associated with these features. The primary requirement of this method is that you should be able to track every item individually with RFID tag, stamped receipt date or a serial number. While this method introduces a high degree of accuracy to the valuation of inventory, it is restricted to valuing rare, high-value items for which such differentiation is needed.

First-In, First-Out (FIFO)

This method is based on the premise that the first inventory purchased is the first to be sold. The remaining assets in inventory are matched to the assets that are most recently purchased or produced. It is one of the most common methods of inventory valuation used by businesses as it is simple and easy to understand. During inflation, the FIFO method yields a higher value of the ending inventory, lower cost of goods sold, and a higher gross profit. Unfortunately, the FIFO model fails to present an accurate depiction of the costs when there is a rapid hike in prices. Also, unlike the LIFO method, it does not offer any tax advantages.

Last-In, First-Out (LIFO)

Under this inventory valuation method, the assumption is that the newer inventory is sold first while the older inventory remains in stock. This method is hardly used by businesses since the older inventories are rarely sold and gradually lose their value. This results in significant loss to the business. The only reason to use LIFO is when businesses expect the inventory cost to increase over time and lead to a price inflation. By moving high-cost inventories to cost of goods sold, the reported profit levels businesses can be lowered. This allows businesses to pay less tax.

Weighted Average Cost

Under the weighted average cost method, the weighted average is used to determine the amount that goes into the cost of goods sold and inventory. Weighted average cost per unit is calculated as follows:

Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory.

This method is commonly used to determine a cost for units that are indistinguishable from one another and it is difficult to track the individual costs.

The costs that can be included in an inventory valuation are:

• Direct labor
• Direct materials
• Factory overhead
• Freight in
• Handling
• Import duties

Inventory valuation is important for the following reasons:

Impact on multiple periods. An incorrect inventory valuation will cause the reported profits in two consecutive periods to be incorrect, because the incorrect ending balance in the first period will be wrong, and it then carries over into the beginning inventory balance in the next reporting period.

Impact on cost of goods sold. When a higher valuation is recorded for ending inventory, this leaves less expense to be charged to the cost of goods sold, and vice versa. Thus, inventory valuation has a major impact on reported profit levels.

Income taxes. The choice of cost-flow method used can alter the amount of income taxes paid. The LIFO method is commonly used in periods of rising prices to reduce income taxes paid.

Loan ratios. If an entity has been issued a loan by a lender, the agreement may include a restriction on the allowable proportions of current assets to current liabilities. If the entity cannot meet the target ratio, the lender can call the loan. Since inventory is frequently the largest component of this current ratio, the inventory valuation can be critical.