Inventory Valuation
Inventory valuation is a critical business process that assigns a monetary value to an organization’s inventory. It involves determining the cost associated with each item in the inventory and the total cost of the inventory.
Inventory valuation is essential for several reasons:
- Financial Reporting: It affects the company’s reported income, total assets, and owner’s equity on the balance sheet and income statement.
- Taxation: The method used for inventory valuation can affect the amount of tax a company owes because it impacts the cost of goods sold (COGS) and thus taxable income.
- Decision Making: Inventory valuation helps management make informed decisions about pricing, manufacturing, budgeting, and more.
There are several methods to value inventory, including:
- FIFO (First-In, First-Out): Assumes that the first goods purchased or manufactured are the first ones sold. In periods of rising prices, this method results in a lower COGS and higher profits.
- LIFO (Last-In, First-Out): Assumes that the last goods purchased or manufactured are the first ones sold. In periods of rising prices, this method results in a higher COGS and lower profits.
- Average Cost Method: Also known as weighted average method, it calculates a new average cost each time inventory is added. The COGS and ending inventory are then based on this average cost.
- Specific Identification: In this method, each item in inventory is individually tracked and valued. This method is often used for large, expensive items like cars or real estate.
Note that the chosen method can significantly affect a company’s reported profits and tax liability. Different countries have different rules regarding inventory valuation for accounting and tax purposes. For example, the use of LIFO is prohibited under IFRS (International Financial Reporting Standards), but it is allowed under US GAAP (Generally Accepted Accounting Principles).
Example of Inventory Valuation
Let’s consider a fictional hardware store that sells a specific type of hammer. The store buys this hammer from its supplier at different prices over time due to changes in supplier costs, inflation, and other factors.
- Purchase 1: 100 hammers @ $10 each
- Purchase 2: 200 hammers @ $12 each
- Purchase 3: 150 hammers @ $11 each
Over a certain period, the store sells 300 hammers.
Now, depending on the inventory valuation method, the Cost of Goods Sold (COGS) and the value of the remaining inventory can be significantly different:
- FIFO (First-In, First-Out): The first hammers sold are the first ones that were purchased. So, the first 100 sold are valued at $10 each and the next 200 sold are valued at $12 each. The COGS is (100*$10) + (200*$12) = $1,000 + $2,400 = $3,400. The remaining inventory is valued at (150*$11) = $1,650.
- LIFO (Last-In, First-Out): The first hammers sold are the last ones that were purchased. So, the first 150 sold are valued at $11 each and the next 150 sold are valued at $12 each. The COGS is (150*$11) + (150*$12) = $1,650 + $1,800 = $3,450. The remaining inventory is valued at (100*$10) = $1,000.
- Average Cost Method: The cost of each hammer sold is the average cost of each hammer in stock at the time of the sale. In this case, the average cost per hammer is the total cost of all hammers purchased divided by the total number of hammers purchased, or ($1,000 + $2,400 + $1,650) / (100 + 200 + 150) = $5,050 / 450 = $11.22 (rounded). So, the COGS is 300 * $11.22 = $3,366, and the value of the remaining inventory is 150 * $11.22 = $1,683.
As you can see, the choice of inventory valuation method can significantly impact the reported cost of goods sold and the value of the remaining inventory. Different methods may be advantageous in different situations, depending on factors like the nature of the business, the specifics of the tax and regulatory environment, and the company’s financial and operational objectives.
