Effective inventory management is crucial for manufacturing businesses, and one of the key aspects of this is inventory valuation. Inventory valuation can be done using a variety of inventory costing methods.
In this article, we’ll explain the importance of inventory valuation and five costing inventory methods you should know.
What is Inventory Valuation and Why Does it Matter?
Inventory valuation assigns a monetary value to a company’s inventory at the end of an accounting period. This is an essential accounting component for a manufacturing business as inventory represents a significant portion of its assets.
Measuring your inventory consistently helps you determine the cost of goods sold and the value of unsold goods. With this information, you’ll have better insights to help maximize profitability through improved:
- Inventory management
- Pricing strategies
- Cash flow management
There are multiple methods of inventory valuation. However, you’ll need to select the method that best fits your business.
5 Methods of Inventory Valuation
Below we’ll dive into inventory valuation methods and when manufacturers and accountants most commonly use them.
1. The Retail Inventory Method
The retail inventory method is used to estimate the value of the ending inventory in a retail store. It’s calculated by using the ratio of cost to the retail price. That ratio is then applied to the total value of the merchandise available for sale to determine the estimated cost of the ending inventory.
The retail inventory method is most often used by retailers who sell a large volume of merchandise at a wide range of prices, such as department stores and discount retailers. It is also used by retailers who have a high rate of inventory turnover, as it allows them to quickly and easily estimate the value of their inventory without having to conduct a physical inventory count.
2. The Specific Identification Method
The specific identification method tracks the cost of each item in the inventory separately which allows for a precise calculation of the cost of goods sold and the value of the ending inventory.
While it is a precise calculation, it can be time-consuming and expensive to implement, especially for businesses with a high volume of inventory.
The specific identification method is commonly used by businesses that deal with unique or high-value items, such as:
- Car dealerships
- Jewelry stores
- Art galleries
It is also used by businesses that have a relatively low volume of inventory because it is more feasible to track the cost of each item individually.
3. The First In, First Out (FIFO) Method
The first in, first out method, also known as FIFO, assumes that the first items purchased are the first items sold. It uses the cost of the oldest items in inventory to calculate the cost of goods sold, while the cost of the most recent items is used to calculate the value of the ending inventory.
The FIFO method is straightforward and easy to implement, making it a popular choice for many businesses, more specifically businesses that deal with:
- Perishable items
- Items with a short shelf life
- Items with an expiration date
Note: QuickBooks has a great resource with examples of the FIFO method.
4. The Last In, First Out (LIFO) Method
The last in, first out method, also known as LIFO, assumes that the most recently purchased or produced items are the first items sold. It takes into account the most recent items in inventory to calculate the cost of goods sold, while the cost of the oldest items is used to calculate the value of the ending inventory.
The LIFO method is commonly used by businesses that want to minimize their tax liability, as it can show a lower taxable income when you use the higher cost of the most recent items to calculate the cost of goods sold.
Typically, businesses that deal with inflation use this method because the higher cost of the most recent items more accurately reflects the current cost of inventory. However, while the LIFO method can result in a lower reported income, it can result in an overstatement of the cost of older inventory items since it assumes the oldest items in inventory are still available for sale, even if they are no longer in demand. This makes it one of the least common costing inventory methods.
5. The Weighted Average Method
The weighted average method calculates the average cost of all of the items in inventory, weighted by the quantity of each item. It divides the total cost of all items in inventory by the total quantity of items in inventory to determine the weighted average cost per unit. The average cost is then used to calculate the cost of goods sold and the value of the ending inventory.
The weighted average method is simple and easy to implement. However, it can result in a loss of detail about the cost of individual items in inventory. This makes it most useful for businesses that have a high volume of inventory and deal with items that are not easily distinguishable from one another and businesses that have a stable cost structure over time.
Use the Right Costing Inventory Methods for Effective Stock Valuation
Choosing the right inventory costing method is crucial for manufacturing businesses to accurately value their stock and make informed decisions about inventory management.
By implementing an effective inventory costing method, businesses can:
- Improve their profitability
- Avoid stockouts
- Maintain a healthy cash flow
With the right inventory management strategy in place, businesses can achieve long-term success and growth.