Inventory valuation methods
There are several different types of inventory valuation methods businesses can use. Here, we examine four methods of valuation: FIFO, LIFO, WAC and the specific identification inventory valuation method.
To begin, it is important to understand whether inventory is an asset (yes, itβs considered a current asset) and clarify the difference between current and noncurrent assets.Β
A current asset is considered current because itβs used to pay bills and ongoing expenses. In contrast, real estate or copyrights are examples of noncurrent assets (also known as fixed assets) because they canβt be quickly converted into cash.Β
Letβs now look at the different types of inventory valuation methods available.
First In, First Out (FIFO) inventory valuation method
First in, first out (FIFO) is an accounting method where the approach is to sell the goods that have been made first before selling the goods that are manufactured later. FIFO is typically used in restaurants and grocery stores because it reduces spoilage or waste.Β
FIFO inventory valuation example
Letβs say that you own a burger joint. Last week, you bought enough raw materials to make 1,000 burgers. Each burger costs $10. Later in the week, you stock up again. Now the price goes up to $15 each. You have 2,000 burgers available to sell but you sell 1,500.Β
Using FIFO, you will assume that the first 1,000 burgers sold at $10 each, and the remaining burgers were sold at $15 each. You have 500 burgers remaining to sell, each valued at $15.Β
Last In, First Out (LIFO) inventory valuation method
This method is the opposite of the FIFO method, where you sell the goods you have most recently received. Industries that may apply this method include plastic and rubber manufacturers or energy companies where the market price of goods rises significantly over time.Β
This method can reduce your profit margins, which, in turn, reduces your taxable income. Its advantage is that income taxes will be lower.
LIFO inventory valuation example
Letβs say that Anna sells crochet bags. Anna exhibits at a local fair, bringing her entire stock of 30 bags:
- 5 blue bags valued at $30 each
- 10 green bags valued at $25 each
- 15 red bags valued at $20 each
Anna has a successful run at the fair and sells 25 bags. She uses the LIFO method to calculate her COGS. This means that Anna sold 15 red bags (valued at $20 each) and 10 green bags (valued at $25 each).
Weighted Average Cost (WAC) inventory valuation method
The WAC method is commonly used when the business finds it difficult to calculate individual unit costs. WAC is calculated by dividing the COGS by the inventory units available.
While this keeps things simple, it can provide an inaccurate valuation of your inventory. As a result, it is possible to sell items at a loss. Industries which use the WAC method include agriculture and manufacturing.
WAC inventory valuation example
Wally Pty Ltd uses the WAC method, and during August, it recorded the following transactions.
