Your Guide to Inventory Valuation Methods with Examples

When you come across the term “inventory valuation”, you’re looking at the cost associated with a business’s inventory. These costs are determined by how a business values its inventory and can affect its income. 

In effect, how inventory is valued by a business affects its profitability and value.

This article provides information on inventory valuation methods to enable business owners to understand the different valuation methods they can use in their inventory management. 

You will learn more about:

• What inventory valuation is
• Why inventory valuation is important
• An overview of different inventory valuation methods
• How inventory is valued
• Which inventory valuation method you should use for your business
• How inventory management software can help you manage inventory valuation
• FAQs and more

What is inventory valuation?

A business has to maintain accounting practices, that is, rules, procedures and standards that govern how financial transactions are recorded and reported. Examples of accounting practices include updating your chart of accounts, creating separate accounting duties, starting a budget and outsourcing payroll processing. 

Inventory valuation is one further example, in which a business values the unsold inventory stock they have when they are preparing their financial statements. Inventory stock is classified as an asset of the business and recording it requires it to have a financial value. This value helps a business to determine its inventory turnover ratio which, in turn, helps it plan its purchasing decisions.

Why is inventory valuation important?

There are multiple factors to consider when inventory is being valued. It is not enough to simply know the quantity of unsold items. You will also need a rate by which you can multiply to achieve a final value. 

As different prices may have been applied for these items throughout the year, a technique must be applied to arrive at a common rate. 

Arriving at an accurate valuation is important because of its corresponding impact on several issues:

• the valuation can affect the cost of goods sold: a higher valuation leaves fewer expenses to be charged to the cost of goods sold (COGS) which, in turn, impacts the profit level
• the valuation can affect multiple financial years: an incorrect inventory valuation that causes incorrectly reported profits will influence the following financial period because incorrect ending balances carry forward into the opening inventory balance of the next reporting period
• the valuation can affect the amount of income tax - business paid: the LIFO (last in, first out) inventory method may be used to place an accounting value on inventory. This is typically done during a period of rising prices to reduce income taxes paid
• the valuation can affect loan ratios: a lender’s loan agreement may include a restriction that reviews the proportion of assets to liabilities. Inventory is typically a large component of this ratio and its valuation can influence whether this ratio is met

While accounting and stock are two distinct components of any business, they are linked. Stock accounting involves calculating stock in accounting terms, whereas stock management is about the tracking and control of the movement of stock. 

Inventory management can be quite a balancing act for small businesses, involving decisions about how orders are filled, process optimisation, the use of suitable inventory formulas, and the management of costs.

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, it’s considered a current asset) and clarify the difference between current and noncurrent assets. 

A current asset is considered current because it’s 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 can’t be quickly converted into cash. 

Let’s 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. 

FIFO inventory valuation example

Let’s 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. 

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. 

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. 

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

Let’s 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.

• Actual total cost of inventory is $106,500
• The total units of inventory are 450
• WAC per unit is $236.66 ($106,500 / 450 units)

Specific identification inventory valuation method

This method is part of a perpetual inventory system and is highly accurate. Inventory may be calculated physically (typically once a month) or perpetually (tracking stock in real-time). This method uses the latter calculation, and groups items based on their purchase date and cost. This makes it easy to calculate ending inventory and ensures costs are aligned with revenue. However, it requires a detailed inventory count.

Specific identification inventory valuation example

Let’s say that you sell antique watches. You begin April with $20,000 worth of inventory and you purchase three watches at $10,000 each. At the end of April, you calculate all associated costs, totalling $5,000.

Using the specific identification method:

• New purchases ($30,000) + beginning inventory ($20,000) - associated costs ($5,000) = COGS ($45,000)
• Subtract $45,000 from your revenue, and this provides your ending inventory valuation, which becomes your beginning inventory for May

How is inventory valued?

Here are the ways to calculate your inventory value based on the various inventory valuation methods discussed so far.

How to calculate inventory value using the FIFO inventory valuation method

• Step 1: Determine the cost of your oldest inventory
• Step 2: Multiply the cost of your oldest inventory by the amount of inventory sold

How to calculate inventory value using the LIFO inventory valuation method

• Step 1: Determine the cost of your latest inventory
• Step 2: Subtract the cost of the inventory that remains unsold

How to calculate inventory value using the WAC inventory valuation method

• Step 1: Determine the cost of goods available for sale
• Step 2: Divide the COGS by the total number of units in the inventory

How to calculate inventory value using the specific identification inventory valuation method

• Step 1: Calculate the COGS
• Step 2: Calculate the ending inventory
• Step 3: Subtract the COGS from your revenue and this provides your ending inventory valuation

Which inventory valuation method should I use for my business?

Your choice of inventory valuation method will depend on several factors, including the unique requirements of your business, your key business goals and market conditions.

Here are several factors to consider when determining the most appropriate method for your business:

Are you considering business expansion and will you be applying for a loan?

Loan agreements consider the stock as collateral. As such, you will want a higher valuation of stock for a more positive lender experience. The FIFO method will provide a higher value for closing inventory.

Are you looking for more ways to save on tax?

How you evaluate your inventory can impact how much your business is taxed. Tax liability is highest with the FIFO method because profit will also be at its highest. However, liability will be lower under the LIFO method as profit margins will be lower.

Does your business experience significant price fluctuations?

If your business experiences significant price fluctuations, you may find the LIFO method attractive for its potential tax benefits. If the cost of producing inventory can change quickly, select a valuation method that is least impacted by changes in materials costs.

Are you committed to this type of valuation for the fiscal year?

Accountants do not recommend changing inventory valuation methods too much or too often within a fiscal year as it can lead to inaccuracies that impact your balance sheet.

Are you keen to attract more investment and keep shareholders happy?

A high profit margin can attract positive attention from potential investors and ensure shareholder satisfaction. The FIFO method may be preferable, particularly in inflationary market conditions, while the LIFO method will suit an environment of falling prices.

How inventory management software can help you manage inventory valuation

A comprehensive accounting solution with a robust inventory management feature, QuickBooks supports customers with their inventory valuation needs. Inventory tracking features and detailed custom inventory reports highlight the total cost of goods sold, enabling business owners to gain insights into inventory valuation and make informed decisions about their inventory.

QuickBooks Online Plus offers a one-stop robust e-commerce solution with an inbuilt inventory management feature. Keep your finger on the pulse for all your business inventory needs.

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