Inventory valuation methods – Inventory represents one of the most valuable assets of a retail business and it is an important component in the company’s balance sheet. This is why retailers must know the value of their inventory.
There are four methods that can be implemented by retailers to find out the value of their inventory, namely LIFO, FIFO, FEFO, and Weighted-Average Cost methods. How do these methods work and what distinguishes them? The following is the detailed explanation
According to the FIFO (First In, First Out) method, items that are first added to inventory have to be removed or sold first, while items that last entered the warehouse will be sold later. This is the most common method used for inventory valuation.
The FIFO method is based on the assumption that the cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern.
For example, a bakery produces 200 loaves of bread on Monday at a cost of $1.5 each, and 200 more on Tuesday at $2 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on the income statement) is $1.5 per loaf, because that was the cost of each of the first loaves. The $2 loaves would be allocated to the ending inventory (on the balance sheet).
LIFO (Last In, First Out) is the opposite of the FIFO method. According to LIFO method, the last items purchased or produced must be sold first, while the first items that arrive in the inventory will be sold later on. Under this method, the cost of the most recent products purchased (or produced) are the first to be expensed as cost of goods sold (COGS)—which means the lower cost of older products will be reported as inventory.
The LIFO method helps companies save on taxes when inflation occurs, due to small profits. However, the use of this method is somewhat more complicated than other inventory valuation methods. The bookkeeping costs are more expensive while the profit or loss is lower.
The LIFO method is banned under the International Financial Reporting Standards (IFRS). There are three reasons why this method is ineffective for use in valuing inventory, firstly because there is a significant difference in earnings. Compared to other inventory valuation methods, the LIFO method causes a significant difference in the operating profit generated.
Secondly, the LIFO method also does not represent the current level of inventory costs. When using this method, you’re unable to figure out the relevant value or the actual state of your inventory. In the end, this reduces the quality of the financial statements themselves. Lastly, this method is often used to manipulate taxes.
The FEFO method is a method in which goods with the nearest expiration period must be removed or sold first, regardless of whether the goods entered the warehouse first or later. The FEFO method is commonly applied by food retailers and pharmacies. Usually, the product with the near-expired products will be placed in the front racks or easily accessible places so that they can be taken immediately by customers. Products with longer shelf life will usually be stored in the warehouse first.
The Weighted-Average Cost method is the midpoint or a combination of the FIFO and LIFO methods. According to this method, the cost of goods available for sale is divided by the number of units available for sale and is commonly used when inventory items are so melded or identical to each other that it is impossible to assign specific costs to single units.
A significant advantage of using the weighted average cost method that it is the simplest way to track inventory expense. You can store inventory stock without the need to designate which batch it belongs to and you don’t need to trace the original cost before pricing items, simply marking up the average price of the stock units.
An issue with the weighted average cost method is when your inventory prices vary widely, where you may not recover the costs of the more expensive units and may even suffering a loss with your sales price. The idea behind the method is that you will make up any loss when you sell the less expensive items. If that doesn’t happen, however, you may end up discontinuing the item, never recovering the losses sustained when selling the pricey units.
Automated Inventory Valuation
Calculating stock values requires precision. Because miscalculations can cause harm to your business, we recommend that you use EQUIP inventory management system that allows you to automatically perform valuation. This fully-integrated software enables you to carry out periodic and perpetual inventory valuation using different methods including FIFO, FEFO, and Average Cost with a high degree of accuracy.