Imagine you manage a manufacturing company that produces furniture. At the end of the fiscal year, you have 500 pieces of furniture in your warehouse, ranging from handcrafted tables to simple chairs.
Both the IRS and your stakeholders expect your year-end reports to include details on the value of that furniture. For the IRS, it’s to determine what you owe in taxes, and for stakeholders, it’s to understand how profitable your business is. That’s why you need the right inventory valuation method to provide accurate numbers. Here’s how to choose the method that’s right for your business.
What is inventory valuation?
Inventory valuation is the process of determining how much your unsold inventory is worth at the end of an accounting period. These numbers show the value of a company’s assets and the overall profitability of the business. How often a business values inventory depends on its reporting period, whether that’s quarterly or at the end of the fiscal year.
There are several different inventory valuation methods, but the IRS requires you to pick one and stick with it. Each of the methods listed in this article is accepted by the IRS. Although you can request a change, it’s important to choose a method that matches your business and its stock to maintain accuracy and consistency.
The importance of inventory valuation
Here are five key benefits of accurate inventory valuation.
1. Financial reporting
Accurate inventory valuation ensures that financial statements reflect the true value of your assets and cost of goods sold (COGS). This precision is essential for stakeholders, investors, and regulatory bodies to have a clear picture of the company’s financial position.
2. Inventory management optimization
Effective inventory valuation helps you identify slow-moving or obsolete stock. This information helps you make better decisions about which items to mark down, kit, or discontinue.
By proactively managing inventory levels, businesses can improve turnover rates and reduce the costs associated with holding unsold goods.
3. Operational efficiency
Knowing how much your inventory is worth enhances operational efficiency by providing critical data on your current stock. You can avoid understocking or stockouts when you understand how much inventory you’re holding and its value, boosting overall business performance.
4. Profitability
Holding inventory can eat into your budget and harm profitability. Comparing how much your unsold inventory is worth to your COGS helps you determine your actual and future profits.
Valuing inventory is also important for inventory forecasting since it shows which stock you should prioritize reordering. If you’re spending too much on goods that aren’t selling, you can adjust ordering or production to match that demand and avoid investing hard-earned funds in inventory that might not sell.
5. Regulatory compliance and taxes
When reporting to the IRS, you’re only taxed on what’s sold — not how much stock you purchased. That means you need to know the value of what you still have on hand to report both numbers. Proper inventory valuation ensures compliance with accounting standards and regulations such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
Compliance also reinforces the integrity of your financial practices, showing stakeholders that you’re running operations effectively.
4 types of inventory valuation methods
Here are the main types of methods to show you how to value inventory, plus example calculations for each.
1. First in, first out (FIFO)
FIFO assumes that the oldest inventory items are sold first. Selling the oldest stock first reduces the risk of obsolescence and spoilage, ensuring inventory is always fresh. This method is often beneficial for businesses selling perishable goods or items with a limited shelf life — but any industry benefits from this straightforward method.
How to value inventory with the FIFO method
- Identify the oldest inventory items
- Calculate the cost of these items
- Multiply the cost by the number of items sold
FIFO formula: Cost of oldest goods x how much inventory is sold = COGS
Suppose you purchased 100 units at $10 each in January and 200 units at $12 each in February. If you sold 150 units by the end of the year, under FIFO, you would consider the first 100 units at $10 and the next 50 units at $12. Therefore, the COGS would be (100 units x $10) + (50 units x $12) = $1,000 + $600 = $1,600.
2. Last in, first out (LIFO)
LIFO assumes that businesses sell the most recently acquired items first. This method benefits businesses with non-perishable goods and fluctuating prices, such as those in manufacturing, mining, and retail of durable goods because it allows them to better match selling costs to market prices. However, LIFO is less suitable for businesses with perishable goods and could complicate the valuation process.
It’s also important to note that you should only choose the LIFO method if you operate entirely in the U.S. The GAAP accepts this method, but it’s prohibited by the IFRS. That means if you plan to expand internationally, you need another valuation method.
How to value inventory with the LIFO method
- Identify the most recently acquired inventory items
- Calculate the cost of these items
- Multiply the cost by the quantity of items sold
LIFO formula: Cost of newest goods x how much inventory is sold = COGS
Using the same numbers as above, under LIFO, you would consider the last 200 units at $12 first. If you sold 150 units, the cost would be 150 units at $12. The COGS would be (150 units x $12) = $1,800. None of the first 100 units would be counted until all 200 units were sold. And the cost of the first 100 units would still not be used if you ordered more units to replace the ones that were sold.
3. Weighted average cost (WAC)
WAC calculates an average cost per unit of inventory by dividing the total cost of goods available for sale by the total number of units available for sale. This method smooths out price fluctuations over time, providing a stable cost basis and making it easier to manage and predict costs. The biggest con of this method is that you might have a harder time matching the flow of your inventory since this is an average.
How to value inventory with the WAC method
- Sum the total cost of goods available for sale
- Divide this total cost by the total number of units available
- Multiply the average cost per unit by the quantity of items sold
WAC formula: (Cost of all goods / number of units) x how much inventory is sold = COGS
Using the previous numbers, you would have: (100 x $10) + (200 x $12) = $3,400. With a total of 300 units available, the weighted average cost per unit is ($3400 / 300 units) = $11.33.
If you sold 150 units, the COGS would be 150 units multiplied by $11.33, totaling $1,699.50.
4. Specific identification
Specific identification tracks the actual cost of each item in inventory. This method is best for businesses dealing with unique, high-value items where each item can be individually identified and tracked. But it takes more time and requires tracking serial numbers or lot numbers, as well as physical counts of each item, so it’s not the best fit for businesses with a large number of SKUs or rapid turnover.
How to value inventory with specific identification
There’s no formula for specific identification. All you have to do is add up the actual cost of every unit, either with a pen and paper or in a database. The key is to be as precise as possible and track items on an individual level to ensure the numbers are correct.
As noted above, this is most easily accomplished with the aid of inventory tracking methods, such as serial numbers, lot numbers, and expiration dates. When each item is tracked in an inventory management solution, its actual cost is automatically added to the total COGS calculation after it’s sold.
Choosing the right inventory valuation method
Selecting the right inventory valuation method is crucial for accurately reflecting your business’s financial health and efficiency. Consider these factors when choosing a method:
- Business needs: Assess your business’s nature, inventory turnover rates, and product lifespan. Choose a method that aligns with your operational needs and market conditions. FIFO is ideal if you sell perishable goods to reduce spoilage, LIFO benefits from price fluctuations, WAC provides stability by averaging costs, and specific identification is good for manufacturers of large goods like cars and industrial equipment.
- Inventory flow: Understand the flow of your inventory and how quickly you’re replenishing stock. If you have a lot of product that sits in a warehouse before distribution, it might benefit from LIFO to match market prices.
- Financial reporting: Your method should match your business’s individual financial reporting needs. WAC might not be a good choice if the value of individual assets ranges from a few dollars to a few thousand.
- Regulatory compliance: The methods listed above comply with accounting standards. Avoid combining methods or making adjustments on your own, which could disrupt financial integrity.
- Professional advice: Consult with accounting professionals or financial advisors to determine the best inventory valuation method for your specific business needs.
Maximize profitability and optimize operations with Fishbowl
Once you’ve chosen a valuation method, you need an inventory management system to track everything. From FIFO to LIFO and beyond, Fishbowl supports precise valuation methods, empowering businesses with efficient inventory control to help you maximize profitability and optimize operations.
Schedule a demo to learn how Fishbowl can enhance your inventory management today.