What Are the Different Inventory Valuation Methods?

At the end of an accounting period, which usually means the end of the fiscal year, you have to prepare financial reports so that the government can tax you properly. If your balance sheet isn’t organised accordingly, you may end up paying more taxes than you should, and nobody wants that, especially business owners. 

Speaking of which, for retail and eCommerce businesses, preparing financial reports pretty much comes down to rummaging through your inventory to determine which items haven’t been sold and what their value is now compared to when you purchased or manufactured them. 

This can be achieved using different inventory valuation methods that best suit your and your company’s needs. So, let’s examine those methods and analyse their advantages as well as disadvantages.

What is Inventory Valuation?

As mentioned before, inventory valuation is an accounting process that helps companies determine the total value of all unsold items or products in their inventory. Since inventory is technically an asset, it has to be included in your financial reports at the end of every fiscal year.

Why Do You Need to Evaluate Inventory?

Inventory valuation has multiple purposes but only one goal, which is to determine your company’s current and future profitability. This may seem like a stretch at best, but the reality is that inventory valuation methods do help business owners better understand their financial position. 

For instance, the purpose of inventory valuation may be to locate all the unsold goods. If you’re running a fresh new business, you may not have a lot of goods to comb through, but once the company grows and you start moving large quantities of products each day, finding unsold items in your warehouse or warehouses becomes more of a challenge. 

You have to do it either way every time you conduct an inventory audit, so you might as well use the same tactics for valuation.

However, the goal remains the same, which is to determine exactly how profitable your company was during the previous accounting period. This is often determined by analysing the costs of goods sold (COGS).

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• COGS = Opening Inventory + Purchases + Direct Expenses - Closing Inventory

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This particular example helps determine gross profits and losses for your company by comparing the costs of goods sold to direct revenue during the accounting period. That being said, aside from helping you determine overall income, inventory valuation also helps with the following:

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• Determining Company’s Financial Position
• Analysing Company’s Liquidity
• Determining Overall Statutory Compliance

Inventory Valuation Methods to Consider

As mentioned before, a retail or eCommerce business can use different inventory valuation methods based on the nature of their business and their individual needs. Each method has a unique approach, as well as a unique set of pros and cons. The methods you can use are as follows:

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• FIFO - First in, First out
• LIFO - Last in, First out
• WAC - Weighted Average Cost
• SI - Specific Identification
• FEFO - First expired, First Out (For goods with expiration date)

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Now, before we delve any deeper into what each method does and how you have to understand that not all methods can be used depending on where you operate from. This is crucial information to know because it will help you choose the best valuation method for your business.

In other words, companies that operate in the US use GAAP inventory valuation methods (Generally Accepted Accounting Practices), while companies operating anywhere else in the world use IFRS methods (International Financial Reporting Standards). 

What’s the difference, you ask? Well, for starters, GAAP allows the use of all their standard methods for valuation, which include WAC, FIFO, SI and LIFO, while IFRS strongly forbids the use of LIFO as a valuation method. Actually, forbids is overstating it a bit; it’s more like IFRS doesn’t recognise LIFO as a method at all. 

But wait, there’s more. Another difference between GAAP and IFRS is how they approach inventory costing and inventory reversal write-downs. So, for example, GAAP records inventory as the lesser of cost or Net Asset Value, while IFRS records inventory as the lesser of costs or Net Realisable Value. 

Now that you know there’s always a catch and that you can never just choose something before doing prior research, we can continue to analyse inventory valuation methods and how to choose the one that suits you most.

FIFO

First in, First out or FIFO method is often an excellent choice for eCommerce businesses. As the name suggests, the items purchased first will also be the items sold first. In other words, your company will use its oldest goods first. 

The main benefit of this method is its simplicity. However, this results in lower COGS and higher gross profits, which also results in higher taxation. Now, that’s not necessarily a bad thing. 

From a business perspective, a higher profit margin means better loan conditions and more investor interest. Sure, you’ll pay higher taxes but you also open new doors for future endeavours that will allow your company to grow.

This method is also beneficial if you’re using a consignment inventory approach. Since FIFO values inventory when companies sell products in the same order they purchase them, the consignment approach allows you to procure goods the moment a customer makes an order, making these two an ideal match. 

LIFO

Last in, first out or LIFO, is a complete opposite of FIFO. It means that your company will use the newest goods to be sold first. 

In other words, the LIFO method assumes that the costs of the latest goods purchased will be the costs of goods sold, almost completely ignoring goods purchased first, not to mention leftover inventory for the previous accounting period or fiscal year, which can be written off as obsolete inventory. 

As a result, your balance sheet shows fewer profits and higher COGS, meaning your company has to pay lower taxes. Technically speaking, your financial report indicates that the company is less profitable when it’s anything but. 

This method is great for managing price swings and hedging against inflation. However, this also means inconsistencies in your balance sheet, which may trigger an audit from the government. It’s also the reason why IFRS doesn’t recognize this method. 

WAC

Weighted Average Cost, or WAC, is somewhat of a middle ground between FIFO and LIFO. Often used by process and discrete manufacturers, as well as retail and eCommerce businesses that don’t have a variety of inventory, WAC allows you to calculate inventory value and costs of goods sold based on the average value of all items purchased within an accounting period. 

Therefore, if you’re selling large quantities of items of the same kind, like jeans, for instance, there’s no need to rely on FIFO or LIFO. Instead, you weigh the average value of a pair of jeans and apply it to all the jeans you bought over a fiscal year. Sure, your items may vary slightly in size or colour but every item is essentially still a pair of jeans, so no reason to divide them in any way. 

SI

SI, or Specific Identification, is the complete opposite of WAC. Instead of valuing the average cost of all items purchased, you’re valuing every individual item in your inventory. Why? To have better accuracy of your inventory costs, of course. 

So, no more grouping products together or dividing them based on model or size. Instead, you’re like an art museum - evaluating each piece you come across. 

This model is ideal for small-medium businesses that don’t have a lot of inventory, and they can value each piece quickly and efficiently. Moreover, if your business produces or sells high-quality/high-value products that you don’t keep a lot of in stock., specific identification is the way to go. 

FEFO

First expired, first out, or FEFO, is pretty much an identical twin to FIFO. The only difference is that instead of using goods that were purchased first to be sold first, you use goods that are about to expire first. 

As you might imagine, this method is used by manufacturers and businesses that sell products with expiration dates or short shelf-life, such as food or pharmaceuticals, for instance. 

Therefore, everything remains the same as in the FIFO method, only this time, you’re preparing your financial report based on selling goods first that are also likely to expire first.

How Do You Choose the Right Valuation Method?

Everything comes down to your needs or your company’s needs, for that matter. If, for example, you wish to take out a business loan to cover some unexpected costs or you wish to invest in new equipment, then FIFO would be a logical choice. 

As you may know, banks tend to look closely at your financial records to determine just how big of a liability you are to them. If they so much as smell that your company isn’t doing as well as they think it should, you’ll get slammed with unfavourable loan conditions, higher interest rates or you might get denied for a loan altogether. 

So, give them a spotless financial statement created using the FIFO method that will portray your company as a low-cost/high-profit venture, and you’ll have the loan handed to you on a silver platter. 

The same approach goes for attracting investor interest. A financial report based on the FIFO method will showcase your company in the best way possible. A profitable endeavour attracts investors and they are more likely to lend you their aid if the reports show a promise of a profitable return on investment.

On the other hand, if you believe the government is taking more than their fair share, it’s time to resort to the LIFO method. 

As mentioned before, LIFO is the opposite of FIFO, and your financial reports will show that your company struggles with higher costs and lower profits, so it would be unkind for the government to burden your company even more with higher taxes. 

As a result, your taxes will be lower, but investor aid and bank loans will be almost out of your reach.

Let Bezos Help Value Your Inventory

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The most tedious aspect of any business is managing finances and financial reports. However, the good thing is that you don’t have to do everything alone. With years of experience in eCommerce fulfilment, Bezos is the type of partner that can greatly help you out in this endeavour. 

Not only can we help value your inventory, but we can also help you choose the best method to do so. We tailor our approach to your business needs, so don’t hesitate to reach out to us. You can even do so today, and we’ll have a solution ready for you in no time. 

Conclusion: Inventory Valuation Methods That Can Help Your Business Flourish

As mentioned before, inventory valuation methods are designed to ensure that your company remains profitable even in the most trying times. Although different methods utilise different approaches, the end result remains the same nonetheless. 

This is why it is essential to understand what each method does and how. This will help you choose the best way forward that will meet your company’s needs. 

All that remains is for you to determine how to develop your company further, may that be by securing investor aid, obtaining a loan or simply by cutting down taxes. In any event, how you value your inventory will secure the means that will help you overcome this challenge.

FAQ:

What are the five methods of inventory valuation?

Inventory valuation can be achieved using one of five different methods. Which method you’ll choose depends entirely on your needs. As for the methods themselves, here are the ones most commonly used by businesses. 

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• FIFO
• LIFO
• WAC
• SI
• FEFO

How to calculate inventory valuation?

Calculating inventory value comes down to the valuation method you’ve opted for. The value itself can be estimated by which goods are sold first, the average of all goods purchased within an accounting period or by specifically identifying each item in your inventory.

What is the inventory valuation method of IFRS?

IFRS, or International Financial Reporting Standards, recognises all valuation methods except LIFO. The main reason is that LIFO doesn’t really depict the actual financial position of your company. Instead, it portrays your financial status as bad enough to ensure lower taxation. Although accepted in the US, LIFO is not recognized as a valuation method in the rest of the world. 

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