How you choose to value your inventory has an impact on multiple elements in your financial statements.
Understanding the four main types of inventory valuation will help you decide which is best for your growing mid-size business. Each inventory valuation method has a unique set of pros and cons making it better suited to certain industries and business structures.
Read on to learn about each inventory valuation method and how you can choose one that’s right for your business.
What is inventory valuation and why is it important?
Inventory is a current asset that refers to the goods for sale or unsold goods. Inventory valuation is the monetary amount that corresponds with the goods in the inventory at the end of any given accounting period.
Usually, you calculate inventory valuation at the end of every financial year to calculate the cost of goods sold and the cost of any unsold inventory.
The valuation is calculated from the costs generated to obtain the inventory and get it ready for sale. As you sell an item from your inventory, it moves from an asset to an expense. In cases of excess or shortage of inventory, there are consequences to the production and profitability of a business.
Accounting for inventory has a direct impact on assets reported on your balance sheet and the cost of goods sold recorded on your income statement.
It’s important to assign the correct monetary amount to inventory because this number slowly converts to an expense and ultimately impacts your company’s bottom line. Analyzing the four main types of inventory valuation will help you decide which is most effective for your mid-size business.
What are the main inventory valuation methods?
There are four key inventory valuation methods that mid-size business owners should know about.
The right method of inventory valuation for a business depends on how it chooses to track stock over time.
FIFO inventory valuation method
The First In, First Out (FIFO) method of inventory valuation assumes the earliest goods you purchase are the ones you sell first—first in, first out. This is based on the idea that the first inventory bought is the first to be sold.
The remaining assets in the inventory are matched to assets that are most recently produced or purchased.
Example of FIFO in action
Imagine that your business buys and sells organic fruit juices. On January 1, you purchase 10,000 units of juice for $0.50 each. On January 4, you purchase another 5,000 units of the same type for a purchase price of $0.75 each. Between these dates and January 10, you sell 12,000 juices.
Under the FIFO method, you sell the goods that were among the first to be purchased. In this case, the 10,000 juices retail at $5 per juice, since the earliest juices you bought cost $0.50 each. The remaining 2,000 juices retail for $7 each, resulting in the 3,000 juices bought at $0.75 each going on your balance sheet as inventory.
Pros of FIFO
- Easy to understand. The principle of selling inventory that you purchase first is simple to grasp.
- Beneficial during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest. For example, you buy a kitchen blender for $25. Six months later, you buy the same kitchen blender for $35. When one of the blenders is eventually sold for $50, the FIFO method dictates the cost of the goods sold is $25. Therefore, the FIFO method is most advantageous when attempting to maximize net income and increase gross profit.
- Avoid inventory expiration or obsolescence. Because you sell older inventory items first, inventory listings have a lower chance of reporting items too old to sell.
Cons of FIFO
- Income taxes are higher. Your company needs more cash to pay that bill.
- Doesn’t accurately show costs. When there’s a quick increase in price, FIFO doesn’t show the price spikes, because current period costs aren’t reported in the current period. This makes the financial statements slightly inaccurate. In the second example above, although you pay $35 for your blender in the current period, the actual expense recognized is only $25. Therefore, you must manage cash flows more actively.
Is FIFO right for my business?
If your business mainly deals in perishable goods like food, beverages, cosmetics, or pharmaceuticals, FIFO is the right inventory valuation method for you. Products that run the risk of expiring need to follow the FIFO method. That way, your goods won’t expire before you’re ready to sell them.
LIFO inventory valuation method
The Last In, First Out (LIFO) method of inventory valuation is the opposite of the FIFO method. Under LIFO, the last inventory items bought are the first ones to be sold.
Example of LIFO in action
Using the same figures from the juice example above, when recording the sale of 12,000 juices under the LIFO method, you record that the juices sold were the last ones bought. In this case, the cost of the juices sold is $0.75.
The only reason to use LIFO is when businesses expect inventory costs to increase over time and result in price inflation. The method isn’t commonly used by businesses because older inventories are hardly sold and lose their value, leading to significant losses.
Pros of LIFO
- Lower tax bills. In inflationary periods, LIFO creates an unreported income tax deferral, therefore lowering tax bills and alleviating cash flow requirements.
- Accurate timing of expense recognition. Expenses are actually reported in the period they occur. In addition, if you want to avoid writing off the future value of inventory, you should opt for this method because inventory is already understated.
Cons of LIFO
- Typically reduces net income. Mid-size businesses must understand and anticipate this from an income tax standpoint.
- Doesn’t align with the actual flow of goods. In certain industries, such as the food industry, LIFO doesn’t accurately align with the real-time purchase and selling of goods. Perishable inventory is best managed under FIFO.
- Only usable in the United States. Currently, the IRS permits LIFO, but the International Financial Reporting Standards (IFRS) doesn't.
Is LIFO right for my business?
LIFO is right for mid-size businesses purchasing low volumes of inventory items of a higher value that won’t expire or go obsolete quickly. Businesses selling high-value items that don’t change value quickly can use LIFO as their inventory valuation method.
Weighted Average cost inventory valuation method
The Weighted Average inventory valuation method applies the same inventory cost to every unit, regardless of the actual cost of each specific item. Weighted Average is used to decide the amount that goes into the cost of goods sold and inventory.
You’ll need to do a bit of math to arrive at your cost per unit.
Weighted Average cost per unit:
Weighted Average cost per unit = Total cost of goods in inventory ÷ Total units in inventory
This method is often used to determine a cost for units that are alike and when it’s difficult to track the individual costs.
Example of the Weighted Average method in action
If you spend $12,000 on two orders that resulted in 15,000 juices, the average price per juice is $0.80. Therefore, when you sell 7,000 juices, the cost of these juices is $0.80, and all remaining juices in ending inventory have a cost of $0.80, regardless of how much you paid for the juice units in each order.
Pros of the weighted-average method
- Quicker and easier method. The clear benefit of the Weighted Average method is its simplicity. You don’t need to track what you sell and when you sell it for inventory-costing purposes. Instead, you maintain only the total dollar amount of inventory and the quantity in stock for each inventory item.
- Standardized expenses across inventory batches. If you have a manufactured batch that has higher than normal waste, the cost of that waste is allocated across all batches, keeping the cost of all items the same.
Cons of the Weighted Average method
- Not ideal for goods of different prices. If you stock lots of goods of varying prices, Weighted Average won’t give you an accurate price. The actual expenses are never explicitly assigned to the items sold.
- Fewer tax benefits. Net income reported under the Weighted Average method always falls between the amount reported under FIFO and LIFO. Therefore, future tax benefits and cash flow advantages are minimized.
Is the Weighted Average method right for my business?
The Weighted Average method is best for businesses stocking high-volume goods that are at the same price point. It’s best for businesses that do fewer orders of goods that are relatively unaffected by price spikes.
Specific identification inventory valuation method
What is the specific identification inventory valuation method?
According to this method, each item in your inventory is tracked from the time it’s stocked to when it’s sold.
It’s best for large items that can be easily identified and have different features and costs.
The top requirement for this method is the ability to track every item individually with an RFID tag, serial number, or a stamped receipt date.
What are the pros of using specific identification?
- High level of accuracy. Using this method, you record the exact cost of each individual inventory item.
- Time-efficient. Once implemented, it’s a time-effective way of tracking goods.
What are the cons of using specific identification?
- Only for limited types of goods. It’s only suited to valuing rare, high-value goods for which differentiation is necessary.
What to consider when choosing an inventory valuation method for your mid-size business
As we mentioned, different inventory valuation methods are best for certain business structures and inventory types. But there are a couple of other factors you should consider too.
Impact of inventory valuation methods on financial statements
In the examples above, the difference between the cost of goods sold under LIFO and FIFO was $0.25 per juice. Using the FIFO method, the cost of each unit is $0.50 for the sale of all 12,000 juice units regardless of the order or sale time. But under the LIFO method, the cost of each juice unit is $0.75 for all 12,000 sold units.
This means the cost of goods sold expense is 25% lower under FIFO. This results in a higher net income and more tax to pay. In addition, the increase in price is buried in your balance sheet.
Considering inflation when choosing a valuation method
When you’re operating in an inflationary economy, the prices of goods purchased increase over time. This means net income is highest under the FIFO method because the cost of goods sold reflects the lowest prices. Meanwhile, inventory is highest under the LIFO method because the last items purchased—at the highest prices—are in inventory.
During inflationary times, when you use average costing calculations for cost of goods sold and inventory calculation, you’ll get numbers between those produced with FIFO and LIFO.
How to select an inventory valuation method
Selecting the right inventory valuation method is essential because it directly impacts your business’s net income, cost of goods sold, and the ending inventory.
Remember, once you've chosen an inventory valuation method, the IRS requires businesses to commit to this method in the first year of filing tax returns.
Here’s a quick guide to how you can select the inventory valuation method that’s right for your inventory type:
- Inventory that experiences falling costs: FIFO
- Inventory that experiences increasing costs: LIFO
- Different stock types of varying values: Specific identification
- Lots of similar inventory: Weighted Average Cost
How do U.S. accounting methods affect balance sheets?
It’s also worth considering how your business’s accounting method influences your balance sheets too.
U.S. GAAP and IFRS Accounting Standards
Accounting methodology in the United States is dictated by U.S. Generally Accepted Accounting Principles, or U.S. GAAP, which were adopted by the U.S. Securities and Exchange Commission.
While progress has been slow, the SEC eventually intends to move from GAAP to IFRS. Both sets of principles define inventory the same way, but there are significant differences between them, and these differences can impact your business.
Measurement of carrying value
The carrying value of inventory is the original cost of the asset less any accumulated depreciation, amortization, or impairments.
GAAP dictates that this value be equal to the lower of either cost or market value, while IFRS states that it should be lower in either cost or net realizable value. In the United States, market value typically means the item’s replacement cost.
Assume you have an inventory item that has an original carry value of $100. The current replacement cost of the inventory item is $85, and its net realizable value is $95. In the United States, the carrying value of this item would be adjusted to $85.
Costing formula
With GAAP, you don’t need to use the same formula you use to determine the cost of inventory across all inventories that have the same nature and use to your small business. Read more about inventory costing and how to calculate it.
Asset retirement obligations
If an asset retirement obligation (ARO) is created during the production of inventory, GAAP states that it’s added to the carrying amount of property, plant, and equipment used to produce the inventory. Under IFRS, this amount is accounted for as a cost of the inventory. It may be added to the carrying amount of your inventory.
Accounting methods
Under GAAP, FIFO (First In, First Out), LIFO (Last In, First Out), weighted average, and specific identification are all acceptable methods of cost determination for your company’s inventory. Under IFRS, on the other hand, LIFO is not permitted, and specific identification is required for certain types of inventory and only in certain cases.
Reversal of write-downs
Under GAAP, write-downs taken to reduce inventories to the lower of their cost or market value cannot be reversed to increase valuations later. Under IFRS, these write-downs are reversible.
Is GAAP or IFRS better?
There is no one-size-fits-all answer. Each set of standards has its strengths and weaknesses. Depending on your type of company and the types of inventories involved, GAAP or IFRS can be more advantageous by causing your balance sheet to increase.
Use the right accounting software for your inventory valuation method
Careful recordkeeping and vigilant monitoring of your inventory is crucial to your success as a growing business. And automating your inventory management systems will help you keep accurate records and ensure you monitor the cost of your inventory.
QuickBooks will provide real-time updates on the state. That way, when you need to pull reports or make important business decisions, you have all the up-to-date data you need. Ready to start using QuickBooks? Learn how QuickBooks Online Advanced can help you value inventory for your growing business.
