Inventory Valuation (Pricing Materials)

Key Takeaways

Inventory Valuation

Inventory valuation is a critical aspect of financial accounting. It involves the determination of the worth of a company’s stock of goods available for sale or use in production. Accurate inventory valuation directly impacts a company’s financial position, performance, and compliance with accounting standards such as IAS 2 (Inventory Valuation Standard) or GAAP (Generally Accepted Accounting Principles).

In this article, we will explore key concepts related to inventory valuation, practical examples, and advanced considerations for ensuring financial accuracy.

Understanding Inventory Valuation

Inventory refers to a collection of items that a company owns, including:

• Goods bought for resale.
• Raw materials and components.
• Partially finished goods and fully finished products.

These items represent current assets on a company’s balance sheet and play a pivotal role in the calculation of cost of goods sold (COGS), profit margins, and overall financial health.

The Importance of Inventory Valuation

Inventory valuation involves determining the value of inventory to report it on the company’s balance sheet accurately. It is crucial because:

1. Financial Reporting: Inventory is a key component of current assets and impacts the accuracy of financial statements.
2. Profit Measurement: Valuation affects the cost of goods sold and ultimately the net income of a business.
3. Compliance: Following established valuation rules ensures compliance with accounting standards like IFRS and GAAP.
4. Decision-Making: Accurate valuation informs pricing, production planning, and inventory management decisions.

Valuation Principles: Lower of Cost and Net Realizable Value

The lower of cost and net realizable value (NRV) principle ensures that inventory is reported conservatively to avoid overstating assets.

Cost of Inventory

The cost of inventory includes:

1. Cost of Purchase:
   • Purchase price, import duties, handling fees, and transportation costs.
   • Less trade discounts and rebates.
   • Example: A retailer purchases 500 units of a product at $10 each, with $500 in shipping fees and a $200 discount. The total cost of purchase = ($10 x 500) + $500 – $200 = $5,300.
2. Cost of Conversion:
   • Direct labor, materials, and manufacturing overheads incurred to produce finished goods.
   • Example: A factory incurs $50 in raw materials, $30 in labor, and $20 in overhead for each unit. The cost of conversion per unit = $50 + $30 + $20 = $100.
3. Excluded Costs:
   • Selling costs, storage costs (unless essential for production), administrative expenses, and abnormal wastage.
   • These costs do not directly contribute to the acquisition or production of inventory.

Net Realizable Value (NRV)

NRV is the estimated selling price less any costs required to complete and sell the inventory.

• Example: A company anticipates selling a batch of items for $1,000 but expects $200 in selling expenses. NRV = $1,000 – $200 = $800.

Example: Valuing Inventory

Inventory valuation methods

Inventory valuation methods refer to the different approaches used to determine the monetary value of the goods held in stock by a business. There are several inventory valuation methods, including First-In-First-Out (FIFO), Last-In-First-Out (LIFO), Weighted Average Cost (WAC), and Specific Identification.

First-In-First-Out (FIFO)

The FIFO method assumes that the first items purchased are the first items sold. Therefore, the cost of the oldest inventory is assigned to the cost of goods sold (COGS), and the cost of the most recent inventory is assigned to ending inventory. This method is best suited for businesses that sell perishable goods that have a limited shelf life.

For example, let’s say a bakery purchases 100 bags of flour at $10 each in January and another 100 bags at $12 each in February. In March, the bakery sells 120 bags of flour. According to the FIFO method, the cost of the first 100 bags sold would be $10 each, and the cost of the remaining 20 bags sold would be $12 each. The value of the ending inventory would be 80 bags at $12 each.

Last-In-First-Out (LIFO)

The LIFO method assumes that the most recent items purchased are the first items sold. Therefore, the cost of the most recent inventory is assigned to the cost of goods sold, and the cost of the oldest inventory is assigned to ending inventory. This method is best suited for businesses that sell non-perishable goods, as the older inventory is less likely to spoil.

For example, let’s say a hardware store purchases 100 hammers at $5 each in January and another 100 at $6 each in February. In March, the hardware store sells 120 hammers. According to the LIFO method, the cost of the first 100 hammers sold would be $6 each, and the cost of the remaining 20 hammers sold would be $5 each. The value of the ending inventory would be 80 hammers at $5 each.

Weighted Average Cost (WAC)

The WAC method calculates the average cost of all inventory items, regardless of when they were purchased. The average cost is then assigned to the cost of goods sold and ending inventory. There are two methos of weighted average Periodic Weighted Average and Continuous Weighted Average:

Specific Identification

The specific identification method assigns the actual cost of each item to the cost of goods sold and ending inventory. This method is best suited for businesses that sell high-value, unique items with identifiable serial numbers, such as cars or jewelry.

For example, let’s say a car dealership purchases three cars, a red one for $20,000, a blue one for $22,000, and a green one for $25,000. The dealership sells the red car for $25,000, the blue car for $24,000, and the green car for $28,000. According to the specific identification method, the cost of goods sold would be $20,000 for the red car, $22,000 for the blue car, and $25,000 for the green car. The value of the ending inventory would be $0 as all cars were sold.

All in all, choosing the appropriate inventory valuation method is critical for businesses to accurately reflect their financial situation. Each method has its advantages and disadvantages, and the selection of the method depends on the nature of the business, the type of inventory, and accounting policies. The choice of inventory valuation method can have a significant impact on a business’s financial statements, particularly on its profitability and taxes. Therefore, it is essential to choose the appropriate method that aligns with the nature of the business and accurately reflects its financial situation.

Impact of inventory valuation methods

The inventory valuation method used by a company can have a significant impact on its reported profit and net assets. This is because the cost of goods sold and the value of ending inventory, which are used in the calculation of profit and net assets, depend on the method used to value inventory.

Let’s consider a company that sells widgets and has the following inventory transactions for the month of January:

• January 1 – Beginning inventory: 100 units at a cost of $5 each
• January 12 – Purchased 200 units at a cost of $6 each
• January 12 – Sold 250 units

To demonstrate the impact of different inventory valuation methods, we will use the same inventory transactions but calculate the cost of goods sold and ending inventory value using four different methods: FIFO, LIFO, weighted average, and specific identification.

FIFO (First-In, First-Out)

Under the FIFO method, the cost of goods sold is calculated based on the assumption that the oldest inventory items are sold first. This means that the cost of the 100 units in beginning inventory is used to calculate the cost of goods sold for the first 100 units sold, and the cost of the 200 units purchased later is used to calculate the cost of goods sold for the remaining 150 units sold. The ending inventory value is based on the cost of the 50 units remaining in stock, which were purchased at the most recent cost.

LIFO (Last-In, First-Out)

Under the LIFO method, the cost of goods sold is calculated based on the assumption that the newest inventory items are sold first. This means that the cost of the 200 units purchased later is used to calculate the cost of goods sold for the first 200 units sold, and the cost of the 100 units in beginning inventory is used to calculate the cost of goods sold for the remaining 50 units sold. The ending inventory value is based on the cost of the 100 units remaining in stock, which were purchased at the lowest cost.

Weighted Average

Under the weighted average method, the cost of goods sold and the value of ending inventory are calculated based on the weighted average cost per unit of inventory. This method was discussed in detail in the previous section, so we won’t repeat the detail here.

Using the example above, the cost of goods sold under the weighted average method would be $1,417.50 = ($5.67 Unit Cost * 250 Unit).
Unit cot is calculated as follows ($500+$1,200)/(100+200) = $5.67, and the ending inventory value would be $283.50 (50*$5.67).

Specific Identification

Under the specific identification method, the cost of goods sold and the value of ending inventory are based on the actual cost of each unit sold or remaining in stock. This method is only feasible if each unit of inventory can be identified and tracked separately, such as in a jewelry store or an art gallery where each item is unique and has a different cost.

As we can see from the above example, the specific identification method results in a more accurate valuation of cost of goods sold and ending inventory, but it is only feasible for companies with unique and identifiable inventory items.

Advantages and Disadvantages of Inventory Valuation Methods

FIFO (First-In, First-Out)

Advantages:

1. Realistic Cost Matching: It matches revenues with older inventory costs, providing a more accurate representation of profit.
2. Tax Benefits: In a falling price environment, using FIFO can result in lower taxable income and, consequently, lower taxes.

Disadvantages:

1. Distorted Profits:
   During periods of inflation, FIFO tends to inflate profits as older, lower-cost inventory is matched with current higher selling prices.
2. Complex Tracking:
   Can be administratively challenging, especially in industries where products are interchangeable.

LIFO (Last-In, First-Out)

Advantages:

1. Tax Advantages: In periods of inflation, LIFO can result in lower taxable income and reduced tax liability.
2. Recent Cost Reflection: Reflects the current market prices of inventory more accurately, especially in inflationary environments.

Disadvantages:

1. Mismatch with Physical Flow:
   LIFO may not represent the actual flow of goods, as newer inventory is often kept in storage while older inventory is sold.
2. Financial Reporting Challenges:
   Can make financial statements less comparable across different companies or periods.

Weighted Average Price

Advantages:

1. Simplicity:
   Easy to calculate and understand, making it a straightforward method for small businesses or those with simple inventory systems.
2. Smoothing Effects:
   It helps mitigate the impact of rapid price changes on the cost of goods sold and ending inventory by averaging costs over time.

Disadvantages:

1. May Not Reflect Current Market Prices:
   In times of significant price fluctuations, the weighted average may not accurately capture the current market prices.
2. Impact of Extreme Costs:
   Significant variations in inventory costs can affect accuracy. The weighted average may not accurately reflect the actual cost of individual units in such cases.

Advanced Considerations

1. Impact of Valuation on Financial Ratios:
   • Overstating inventory inflates current assets and can distort liquidity ratios like the current ratio.
   • Undervaluation reduces profitability by increasing COGS.
2. Global Variations in Standards:
   • While IAS 2 emphasizes lower of cost and NRV, some regional practices, like LIFO, are not permitted under IFRS but are acceptable under GAAP.
3. Technology and Tools:
   • Modern inventory management systems (e.g., ERP software) streamline valuation by automating calculations based on real-time data.

Challenges in Inventory Valuation

• Market Fluctuations: Rapid price changes can complicate valuation.
• Obsolescence: Outdated inventory may need significant write-downs.
• Errors in Cost Allocation: Misclassifying indirect costs can lead to inaccurate valuations.

FAQs

1. What happens if inventory is overvalued?
   • Overvaluation inflates assets and reduces COGS, leading to overstated profits.
2. Which inventory method is best?
   • It depends on the industry. FIFO is common for perishables, while weighted average suits homogeneous products.
3. How do businesses handle obsolescence?
   • Obsolete inventory is written down to NRV or removed from financial statements entirely.

Key takeaways

• Inventory should be valued at the lower of cost and net realizable value. This involves comparing the acquisition or production cost to the expected selling price.
• Inventory costs include purchase, conversion, handling, and transportation costs. Selling, storage, and administrative expenses should not be included in inventory valuation.
• Different inventory valuation methods include FIFO, LIFO, weighted average, and specific identification, each with its own impact on financial statements.
• FIFO assumes older items are sold first. LIFO assumes newer items are sold first. Weighted average calculates an average cost. Specific identification tracks actual costs for each unit.
• Specific identification provides the most accurate valuation but is practical only for businesses with unique, identifiable inventory items.
• FIFO (First-In, First-Out) offers realistic cost matching, aligning revenues with older inventory costs for accurate profit representation. It’s a tax-savvy method in falling price scenarios, but beware of profit inflation during inflationary periods.
• LIFO (Last-In, First-Out) comes with tax advantages in inflation, reflecting current market prices accurately. However, it may not mirror the actual flow of goods and can pose financial reporting challenges, making comparisons tricky.
• Opt for simplicity with Weighted Average Price, offering ease in calculation and a smoothing effect to mitigate rapid price changes’ impact. But be cautious—it may not always capture current market prices accurately, especially in times of significant fluctuations.

Full Tutorial

Further Reading:
Inventory Accounting
Managing Materials: Costs and Processes
Inventory Monitoring
Inventory Management Systems
Best practices of inventory management and visibility