Valuing your inventory has a direct impact on a number of financial statement elements. As an item of inventory gets sold, it is moved from an asset to an expense. Therefore, it is important to assign the right dollar amount to inventory because this amount is slowly converted to an expense and ultimately impacts your companys bottom line. In general, there are three inventory valuation methods you can elect to use.
With the FIFO method, the oldest items of inventory are sold first. This inventory method is most beneficial for a small business during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest. For example, say a retail store bought an item of inventory for $25. Six months later, it bought the same piece of inventory for $35. When one of the items is eventually sold for $50, the FIFO method dictates the cost of the good sold was $25. Therefore, the FIFO method is most advantageous when attempting to maximize net income. Another advantage of the FIFO method is it conceptually avoids obsolescence. Because older inventory items are sold first, inventory listings have a lower chance of reporting items too old to sell. However, there are drawbacks to the FIFO method. Income taxes are higher, and the company has the need for more cash to pay the bill. In addition, current period costs are not reported in the current period. This makes the financial statements slightly inaccurate. In the example above, although $35 was paid in the current period, the actual expense recognized is only $25. Therefore, a company must actively manage cash flows.
With the LIFO inventory method, the last inventory items bought are the first ones to be sold. When selecting the LIFO method in an inflationary period, a companys tax bill is lower. This alleviates cash flow requirements, and an unreported income tax deferral is created. Another advantage is the accuracy of the timing of expense recognition. Expenses are actually reported in the period they occur. In addition, a company that wishes to avoid having to write off the future value of inventory should opt for this method. This is because inventory is already understated. A potential downside to the LIFO method is net income is typically reduced. Opposed to the FIFO method, income is lower. In addition, future net income is higher, a fact a small business must understand and plan for from an income-tax standpoint. Another downside to the LIFO method is it may not align with the actual flow of goods in certain industries such as the food industry. A company that handles perishable goods physically sells the oldest inventory goods first, assuming the products are still good.
The weighted-average inventory method applies the same inventory cost to every unit, regardless of the actual cost of each specific item. The clear benefit of the weighted-average method is its simplicity. A company does not need to track what was sold and when it was sold for inventory-costing purposes. Instead, it must only maintain the total dollar amount of inventory and the quantity in stock for each inventory item. In addition, a company wanting to standardize expenses across inventory batches should opt for this method. For example, a manufactured batch that had additional waste has the cost of the waste allocated across all batches, keeping the cost of all items the same. However, this results in several disadvantages. First, the weighted-average method does not match any inventory flow. Dollar amounts are arbitrarily assigned, so the expenses never match the associated items sold. Net income reported under the weighted-average method always falls between the amount reported under FIFO and LIFO. Therefore, the future tax benefits and cash flow advantages are minimized.
How to Select an Inventory Method
A small business should consider a few elements when selecting an inventory method. First, it needs to identify the cash flow implications and evaluate what cash flow will look like in the next three to five years. Second, it should understand the impacts on the financial statements. Will it benefit most from having higher net income? Does its balance sheet need to report higher assets for financing purposes? Third, a business should consider the actual flow of materials. The selection made must be substantiated, an element especially important if the inventory does flow in a specific manner. Ultimately, the FIFO, LIFO, and weighted-average inventory valuation methods grant a business flexibility in financial reporting. As a small business owner, you want to understand the implications of each method, and enjoy the benefit of having the freedom to choose which method works best for your business.