What is Inventory valuation?

Inventory valuation is a process to measure the cost of unsold goods and assign a monetary value to items in inventory at the end of the reporting period. It estimates inventories’ true worth, based on how inventory units are sold. The items in inventory include finished goods, goods in the production process, and raw materials utilized in production. Inventory is classified as a current asset on the balance sheet, which is used in the calculation of the current ratio and working capital. The inventory valuation is important for developing accurate financial statements, equalizing revenue & expenses, and concluding with the right business decisions. It affects assets reported on the balance sheet and cost of goods sold, net income, and income tax recorded on the income statement. The costs associated with inventory valuation and getting items prepared for sale are labor, raw materials, factory overhead, and freight. The selling and administrative costs are not part of the costs of inventory. The higher the costs of goods sold, the lesser the profit. The ending inventory is calculated as Beginning Inventory + Net Purchases – Cost of Goods Sold = Ending Inventory 

Inventory Valuation Methods

The inventory valuation methods are based on cost flow assumptions:

 

First-In, First-Out (FIFO):

Assumes that the first units acquired or manufactured are the first units sold.  It calculates the cost of goods sold from old inventory and new inventory calculates ending inventory value. It is an aggressive accounting method. During inflation, FIFO will conclude in the least cost of goods sold and topmost net income calculation.

Last-In, First-Out (LIFO):

Assumes that the last units acquired or manufactured are the first units sold. So, the cost of goods sold is determined from newer inventory and older inventory is the basis for the calculation of ending inventory value. It is the opposite of the FIFO method. The LIFO method is used uniquely in both periodic inventory systems and perpetual inventory systems.  During inflation, LIFO will conclude in the topmost cost of goods sold and the least net income calculation.

LIFO Reserve:

Is the difference between FIFO and LIFO inventory valuation. It is used to understand the comparison between FIFO and LIFO inventory valuation methods.

• LIFO is most suitable in an inflationary environment, as it decreases taxes paid.
• LIFO is not appropriate to evaluate current situations.
• Specific identification method: In this method, the specific cost of items in inventory is calculated. Each item sold and remaining in inventory is recognized. The cost of goods sold is calculated from items sold and items remaining in inventory estimates ending inventory value.
• Weighted average cost method: Average cost of all units purchased is used to determine the cost of goods sold and ending inventory.

The non-cost inventory valuation method is based on lower of its cost or net realizable value. Net realizable value is defined as the selling price of inventory deducting costs of divesting and completion.

The following are the inventory accounting systems:

• Perpetual inventory system: notes each sale transaction and records changes in inventory and cost of goods sold. It provides updated records on each transaction and the FIFO method is commonly used.
• Periodic inventory system: changes in inventory and cost of goods sold are recorded on a periodic basis. Records are not updated on each transaction.
• LIFO and FIFO methods: are used in both perpetual and periodic inventory accounting systems.

Let us understand the importance of inventory valuation

• Tax Purpose: The selection of inventory valuation method, affects the amount of income taxes. During inflation, the LIFO method will decrease income taxes.
• Profitability: Higher inventory values, are directly related to profit levels and inversely related to costs of goods sold.
• Obtaining Loan: Inventory is used as collateral to obtain financing.
• Investment purpose: Matching revenue and expense amount for making investment decisions.

Conclusion

During inflation, the cost of goods sold increases.  FIFO method will report the highest net income as the cost of goods sold indicate the old prices. LIFO method will report the highest inventory as the costs of goods sold is high during the inflationary time. The weighted average cost method results in a cost of goods sold and inventory which is between the values of FIFO and LIFO. LIFO is a preferred inventory valuation method utilized for industries such as construction, automotive, petroleum, metal, furniture, and electronics. FIFO method is favored for inventory valuation of perishable products including fruits and vegetables. Banks and railway sectors also utilize the FIFO method. The weighted average method is used in the agriculture, chemical, pharmaceuticals, and petroleum industries. The specific identification method is used for specific items including jewelry and collectible items.

Author: Rabia J. –  Sr. Analyst