3 most common methods of valuing inventory
Inventory valuation is one of the most important financial details a business owner or accounting team must deal with.
Accurate inventory management is critical to evaluate logistics, employee productivity, and warehouse efficiency and to successfully handle customer and supplier orders. Let’s discuss the three most popular methods of inventory valuation.
FIFO: First in, first out method
The first accounting method is FIFO, which is highly intuitive. Using the FIFO method, the goods you purchase or make first are sold first.
The advantage of FIFO is that it reduces spoilage, obsolescence, and other forms of waste by minimising the time units spent in your inventory before being sold. The disadvantage of FIFO is that it tends to provide an overly optimistic view of financial performance due to the fact that prices, as a general rule, tend to rise over time.
Example industries: Restaurants, grocery stores, and other sellers of perishable goods.
LIFO: Last in, first out method
The LIFO method is the inverse of FIFO. Companies that use the LIFO method always sell whatever goods or materials they received most recently, as opposed to whatever goods they received first.
Companies using LIFO will likely calculate lower earnings and financial statements than companies using FIFO. The advantage of this practice is that income taxes will be lower. But LIFO carries disadvantages when trying to acquire lending from banks or outside investments.
Important note:
LIFO is not an acceptable method under the IFRS (International Financial Reporting Standards) regulations. However, it is an acceptable method for Australian companies who are governed by GAAP (Generally Accepted Accounting Practices) regulations.
Example industries: Plastic and rubber manufacturers, energy, and other industries where the market price of goods rises significantly over time.
WAC: Weighted average cost method
The WAC method is a simplified version of accounting that is considered a good starting point for retailers. It is also commonly used by businesses who find it difficult to calculate individual unit costs.
WAC is calculated by dividing the cost of goods sold (COGS) by the number of inventory units available. The advantage of the WAC method is that it simplifies your accounting procedures. The disadvantage is that it can provide an inaccurate valuation of the items in your inventory, which can result in selling items at a loss.
Example industries: Agriculture, manufacturing, and any other industry where calculating individual unit costs is especially burdensome.
