“Inventory” is the term used for the goods intended for sale or raw materials which will be used in producing the finished goods. “Inventory valuation” is a process of assigning a monetary value to inventory at the end of reporting period. The inventory change can be determined by the following equation:
Start with the inventory the company has in the beginning, add the inventory purchased over the period, subtract the inventory that has been sold and it will give you inventory at the end of the period.
Objectives of Inventory Valuation
Determination of Accurate Income Statement: Inventory valuation is critical as the reported amount of inventory should provide reasonable estimate of cost of goods sold (COGS). Cost of goods sold can be computed from the above equation by adjusting beginning and ending inventory, shown as below:
Cost of Goods Sold (COGS) = Beginning Inventory + Net Purchases – Ending Inventory
Now, from the equation it can be implied that inventory value affects the COGS and thereby, gross profit (which is excess of sales over COGS) and net income. For example, over valuation of ending inventory will decrease the COGS and enhance the profit for current year and therefore, will diminish the reported profits of subsequent years.
Determination of Financial position: Inventory forms an important part of current assets of a business and the ending inventory is shown as current assets in the balance sheet. With inventory being the largest component of current assets for most businesses, accurate measurement of inventory becomes even more critical as overvaluation/undervaluation of inventory can significantly affect the working capital and owner’s equity.
Therefore, reasonable measurement of inventory is paramount for meaningful financial statements and effective decision-making.
How to value Inventory?
Calculating cost of goods sold (COGS) in real life is a bit complex if a business is facing changing per unit inventory cost as, order in which costs are eliminated from the inventory can differ significantly from the order in which goods are physically removed from the inventory. The value of inventory depends on the accounting method that the company decides to utilize to determine cost which explicitly impacts the income statement, balance sheet and cash flow statement. There are three inventory- valuation method used widely by public and private companies.
Let’s understand the inventory valuation with an example. XYZ has business of selling cotton shirts online. He gets all the shirts at a cost of $4 per shirt from his vendor. After few months, there was a surge in the prices of cotton due to which the vendor increased its prices to $4.5 per shirt. Subsequently, with further increase in cotton prices the vendor increased the prices to $5 per shirt. XYZ has purchased the shirts from the vendor in 3 batches (100 shirts in each batch) during different time periods. This is summarized in table below:
|Batch No.||Number of Units||Cost per Unit||Total Cost|
Considering the details of the three batches received by XYZ and the fact that he would not be able to sell exactly 100 shirts during each period and would sell the shirts as per the orders received, what should be the COGS for 125 shirts, order of which is placed with XYZ after he received the 3rd batch?
The answer of the question depends on the inventory valuation method used by XYZ. The three most commonly used inventory valuation methods are known as FIFO, LIFO, and Weighted Average Cost.
First-In, First-Out (FIFO)
The FIFO (First-in, First-out) method of inventory valuation assumes that inventory is sold in an order in which they are purchased/produced. This means that the cost of the first goods purchased/produced are charged to cost of goods sold when the company sells the goods and ending inventory is formed of goods which are purchased/produced later. So, in above example, if XYZ chooses to use FIFO method, the cost of goods sold will be taken from the cost of first 125 units purchased. Hence, in this FIFO method example, the cost of goods sold (COGS) will be equal to:
(100*$4) + (25*$4.5) = $512.5
Last-In, First-Out (LIFO)
Under the “LIFO (Last-in, First-out)” method of inventory costing works on the opposite assumption. Here it is assumed that the last goods to enter in the inventory are first ones to be sold and thereby, the older units remain in the inventory. With refence to the above example, is XYZ chooses to use LIFO method of inventory valuation, the cost of goods sold will be calculated from the cost of the last 125 units purchased. Hence, in this LIFO method example, the cost of goods sold (COGS) will be equal to:
(100*$5) + (25*$4.5) = $612.5
Weighted Average Cost
Under the weighted average cost method of inventory valuation, average cost per unit is calculated for all units available in the inventory during an accounting period. The weighted average cost is calculated as:
In the above example, if XYZ chooses to use weighted average cost method, the cost of goods sold (COGS) will be:
The average cost per unit = [(100*$4) + (100*$4.5) + (100*$5)]/300
= [400 + 450 + 500]/300
Hence the cost of goods sold (COGS) will be equal to: (125*$4.5) = $562.5
Importance of Inventory Valuation for Investors
Effect on Income Taxes: The choice of inventory valuation method can increase or decrease the income levels and therefore, the amount of income taxes paid by the company. If ending inventory of the company is recorded at a higher valuation (or lower valuation) and less expense (or higher expense) is charged to the cost of goods sold, it will impact the reported income which will in turn impact the income tax incurred.
Used as Collateral for Short-term Loans: The short-term creditors are concerned with the liquidity positions of the business and the loan agreement may also constitute a restriction on permitted proportions of current assets to current liabilities. Therefore, proper inventory valuation is required to make sure that inventory as a part of current assets is not exaggerated to misrepresent the liquidity positions of the business.
Impacts Ratio Analysis: There are various ratio that provides quantitative and qualitative information about the company’s financial health. These ratios are used by internal management and by prospective investors, creditors and other stakeholders for making effective and informed decision making. Each inventory valuation method produces different results for various financial ratios which are further used for financial analysis. Use of LIFO, FIFO and weighted average cost method would produce different current ratio, inventory turnover ratio and gross profit margin results.
Since, change in inventory valuation method can have huge effects on the bottom line and other line items, the companies are required to mention in the notes as to what inventory valuation method is used.
Buying/Selling the business: If there is a buyer for a business which has significant inventory levels, the buyer will have to compensate the seller for the inventory levels in the business. The seller would want to value the inventory as high as possible whereas it is buyer’s best interest to value the inventory at the lowest value possible. Therefore, proper inventory valuation is required to preserve the interests of both the parties.
Income statement and balance sheet of the company provide investors and other stakeholders insights into the financial health of the company. The financial statements which are meant to provide true picture of company’s financial and operational conditions are sometimes misstated in such a way that the inventors are convinced that the company is performing exceptionally good. Inventory which forms largest portion of the current assets, is one of the most commonly manipulated assets for misrepresenting operational efficiency of the company.
Companies can choose inventory valuation method which would artificially increase or decrease the bottom line and therefore, the financial position of the company. Therefore, understanding and evaluating the inventory calculation is of paramount importance while making an investment in a company.
Author: Swati J. – Analyst