Inventory valuation methods are an important part of inventory management, allowing you to calculate COGS and put a value on your remaining inventory levels. In this article, we explore these but be sure to read to the end to learn how to handle calculations when performing one of these methods.
Counting your inventory at the end of a period is no fun task, especially when there are several ways you can calculate how much you’ve sold and how many items are going to be carried over into the next period.
No one wants to do it,and there’s no enjoyment in it,but as a Navy Seal once said in an inspirational YouTube video, you got to “Make your bed.”
That’s why we’veinvestigatedthe different types ofinventory valuation methodsyour businesscan use when checking in on your stock levels.
Butwhy are inventory valuations important?
Production costs change over time due to inflation or bottlenecks on your shop floor, so these methods allow you to work out the actual value of your products.
But, as welook intowhat is the purpose of inventory valuation methods, we’re going to give you the secret to, regardless of whichone youdecideto use,optimizing them for your business.
So, in this article, we’re going to look atwhat areinventory valuation methods,some of theinventory valuation methodsexamples, and thebesttool for making them work.
What Are Inventory Valuation Methods?
Inventory valuation methodsarean importantinventory managementpractice of applying a monetary valuetoa manufacturer’sproducts, that make up their inventory at the end of a reporting period.
The idea is that the costs to produce products change over time and performing one of the manyinventory valuation methodsallows you to allocate costs correctly to your sales and your remaining inventory.
So, when looking atwhat is the purpose ofinventory valuation methods, you need to understandhowis inventory valuationcalculated.
And the key aspect of theinventory methodsis calculating yourcost of goods sold(COGS)– which appears as a current asset on a balance sheet –andyour current inventory levelsatthe end of a reporting period– as an expense.
Regardless of whichinventory methodsyou decide to use, it doesn’t include the administrative or selling costs of inventory.
However, the coststhat areassociated withinventory valuation methodsare:
— Handling; and
— Any import duties.
So,you knowwhatis the purpose ofinventory valuation methods,butnowcomes the difficult part,actually choosinga method!
Let’s look at each tactic, theirinventory valuation methodsexamples, along with their advantages and disadvantages.
The First-in-First-Out Method (FIFO)
First in, first out is probably one of the most utilizedinventory valuation methodsused by modern product-making businesses, especially ones that handle perishable goods.
When practicing FIFO, a business is aiming to sell the products they manufactured in the order they were created.
To simplify the process, your oldest products in stock are the first to be sold.
Tracking the finances of FIFO means that you simply charge the older inventory to the cost of goods sold (COGS) as soon as it’s sold and calculate the remaining costs of inventory left on the shelf at the end ofareportingperiod.
An Example of FIFO
There’s an entrepreneur who makes t-shirts with some post-modern slogan which they believe is going to sell like hotcakes.
The maker manufactures100 t-shirts that cost $10 to produce.
At the end of the month, the trendy designer managed to sell 34 shirts.
Using FIFO, the calculation would look like this:
COGS= (34 t-shirts x $10 FIFO cost) = $340
Then the business will need to calculate the cost of inventory that wasn’t sold andis carried over to next month:
Remaining Inventory Value= (66 shirts x $10 cost to make) = $660
Advantages and Disadvantages of Using FIFO
The four distinct advantages to usinginventory valuation methodssuch as FIFO is:
— It’s very easy to apply;
— The flow of costs corresponds with the actual physical flow of goods;
— It eliminates the chance to manipulate income; and
— The balance sheet is more likely to approximate the current market value.
FIFO removes the cost from the oldest units in inventory as soon as the company sells them.
These advantages experienced from using FIFO to manage inventory means any products produced toward the end of a period don’t affect the COGS or net income.
However, a disadvantage to using FIFO includes the recognition of paper profits, and a bigger tax burden if used for tax purposes in a period of inflation.
Last-in-Fast-Out (The LIFO Method)
Last in, last out is another of theinventory valuation methods,which isthe complete opposite ofFIFO.When using theLIFO method, the newest inventory is sold first, withthe older inventory sticking around on your shelves.
So, as the costs of manufacturing increase, the COGS inthe LIFO inventory method assumes that the cost of the latest units purchased arehigher, and the ending inventory balance is lower.
But, before we move on,FIFO vs LIFO, a rule of thumb is that if you’re going to practice one of theseinventory valuation methods, FIFO is perfect for those who have a short expiry date on their products and inventory with a long life is better suited for LIFO.
An Example of the LIFO Method
Let’s use the above genius entrepreneur who repurposes memes by printing them on t-shirts for financial gain.
Using the same example, but instead, the t-shirt maker has decided to usetheLIFO method.
100 t-shirts are produced at $10. But this time, the entrepreneur producesanother 100 t-shirts. However, the second batch costs $12 to produce due to inflation.
The same as before, the t-shirt maker is only able to sell 34 t-shirts.
The formula fortheLIFOmethodwould look something like this:
COGS= (34 shirts x $12 LIFO cost) = $408
The maker still has 166 shirts in stock, 100 shirts at $10 and 66 shirts at $12.
This would mean:
Remaining Inventory Value= (100 shirts at $10) + (66 shirts at $12) = $1,792
Advantages and Disadvantages of Using the LIFO Method
You might be wondering why someone would use this method of inventory valuation, but the biggest advantage to using LIFO, especially during periods of inflation,isthatthe newest costs charged to COGSarealso the highest costs.
Companies who like to use theLIFO methodbelieve it leads to a better matching of costs and revenues. This is because the income statement reports both the sales revenue and COGS in the current value of the selling price.
LIFO’s gross margin is a better indicator to generate income than the gross margin calculated using FIFO.
However, the disadvantages of using theLIFO methodis that if you’re a manufacturer who handles perishable goods, then this method isn’t going to be viable.
The other issues modern manufacturers will face are that if you’re selling your newest inventory, it means you’re going to potentially generatedead stockandincreaseyourcarrying costs.
Moving Average Inventory Costs (MAC) Inventory Valuation
Moving average inventory costs is acostingmethod used under the perpetual inventory system.
When using MAC, you essentially work out the costs of your inventory in real-time. So, when you finish production on an item orpurchase more material, the value of the new order is added to the value of your inventory, then divided by your current inventory levels.
MACmight sound complicated at first glance.
However, comparing it to FIFO vs LIFO, the difference in using WAC instead of those is that your inventory and COGS are based on the average cost of all your items based on fulfilling orders.
An Example of Moving Average Inventory Costs
For old times’ sake, let’s once again use the example of the t-shirt maker and their final inventory level when finishing the two batches during one period.
Instead this time, the t-shirt maker has sold 34 shirtsfrom their first batch of 100 (valued at $10) and just finished their second batch (which cost$12).
Once you have your new inventory levels, you use your new total stock value, and divide it by the total amount of inventory, to get the total average cost of your inventory.
So, using the MAC method the theory will look something like this:
COGS= (66 t-shirts at $10) +(100 t-shirts at $12)÷166 t-shirts =$11.20
Advantages and Disadvantages of Using MAC
The biggest advantage of using MAC is that it’s an incredibly simple way to track inventory expensescompared to other inventory costing methods.
You can store inventory regardless of which batch it belongs to. Once you’ve taken units out of inventory, you don’t need to track their original costs before pricing them.
UsingMAC,you simply mark up the average price of the units, making picking and pricing you inventory hassle-free.
However, an issue of using inventory valuation methods, like moving average inventory cost is that it assumes thatyourproducts areidentical, which for the most part is not the case.
To use MAC appropriately, you will need to track the average costs of your entire inventory and the different types of tools you use.