Painting an accurate picture of your inventory costing isn’t exactly the easiest thing to do if you’re shipping a lot of orders each month. However, inventory management has a huge impact on profitability, so the more you understand which goods sell quickly, which goods get held up, when to run a sale and so on, the better equipped you are to make the right choices going forward.
As an eCommerce business, understanding the value of your inventory is an important aspect of inventory management. Inventory is often your greatest asset, so knowing where you stand is imperative for decision making.
Similarly, when the end of the financial year or accounting period approaches, having an accurate valuation of your inventory is required for accurate bookkeeping.
Today, we’re going to be taking a look at some popular inventory valuation methods that you can use to calculate the value of your goods.
In this article
What is an inventory valuation method?
In essence, an inventory valuation method is a calculation that eCommerce businesses and retailers use to work out an accurate value for their current inventory. There are several different methods businesses can use, with each one having its own advantages and disadvantages depending on the circumstance.
We’re going to look at three popular inventory valuation methods today — the First-In, First-Out method (FIFO), the Last-In, First-Out method (LIFO) and the Weighted Average Cost Method.
Why is inventory valuation important?
Inventory valuation is a critical aspect of financial management for businesses across industries. Let’s explore why it holds such significance and how it impacts various facets of a company’s operations.
Affects the Cost of Sold Goods
One of the primary reasons inventory valuation is crucial is its direct impact on the cost of goods sold (COGS). Proper valuation ensures that the cost of goods sold accurately reflects the cost of inventory consumed during a specific period.
Evaluates the financial status of the company
Inventory valuation provides insight into the financial health of a company. By accurately valuing inventory, businesses can present a true and fair view of their financial position in financial statements.
Impact throughout multiple periods
Inventory valuation doesn’t just affect the current financial period; it also has repercussions on future periods. Changes in inventory valuation methods or adjustments can impact financial statements in subsequent periods, affecting comparisons and trend analysis.
Changes in loan ratios
For companies that rely on external financing, such as loans, inventory valuation plays a crucial role in determining loan ratios. Lenders often assess a company’s inventory value to determine its borrowing capacity and financial stability.
Evaluates gross profit
Accurate inventory valuation is essential for calculating gross profit. Gross profit is a key performance indicator that measures a company’s profitability after accounting for the cost of goods sold. Investors and analysts use this metric to assess a company’s operational efficiency and profitability.
Bringing in investors
Investors scrutinise inventory valuation to gauge a company’s financial performance and potential for future growth. A well-managed inventory valuation process instil confidence in investors, attracting capital investment and fostering business growth opportunities.
Pleasing shareholders
Shareholders, like investors, rely on accurate financial reporting to assess the monetary value of their investments. Proper inventory valuation ensures transparency and credibility in financial statements, enhancing shareholder confidence and satisfaction.
Liquidity evaluation
Inventory valuation impacts a company’s liquidity position. By accurately valuing inventory, businesses can assess their ability to meet short-term obligations and maintain liquidity. This is particularly crucial during periods of economic uncertainty or cash flow challenges.
Statutory compliance
Regulatory bodies often require businesses to adhere to specific inventory valuation methods and guidelines. Compliance with these regulations ensures that financial statements accurately reflect the company’s financial position and performance, mitigating legal and regulatory risks.
Income tax effects
Inventory valuation directly affects a company’s tax liabilities. Different valuation methods can result in variations in taxable income, affecting the amount of income tax owed to tax authorities.
Proper inventory valuation ensures compliance with tax laws and optimisation of tax liabilities.
Top 3 Inventory valuation methods
There are many different inventory valuation methods that you can use to determine your inventory costs, from the Specific Identification Method to the Weighted Average Cost Method. We’re going to cover the top three inventory valuation methods, so here they are!
Inventory Valuation Method 1: First-In, First-Out
The First-In, First-Out method (FIFO) is a fairly accessible inventory valuation method. It takes the assumption that the items you buy first are the first to be sold.
Imagine a conveyor belt representing your fulfilment process. When you buy an item from a supplier, it gets put on the conveyor belt, and gets taken off once it reaches the customer.
The FIFO method assumes that all your items will be placed on this conveyor belt in order of purchase, and not jumbled around as they ride the conveyor belt. Here’s the FIFO inventory valuation method:
Value of Inventory = Number of Newest Remaining Units x Purchase Cost
To illustrate how the FIFO method works, let’s look at a hypothetical scenario. Imagine you run a small business selling candles.
Over a three month period, your candle business bought:
- 50 candles in September, for £3
- 100 candles in October, for £5
- 100 candles in November for £4
Altogether, your candle business bought 250 candles. Let’s say they sold 150 of them, leaving 100 candles still in stock.
The FIFO method assumes that you would have sold all of the candles worth £3, and all of the candles worth £5, as you bought these first. Therefore, we simply multiply the the amount of candles bought in November by the amount paid for them:
Value of Inventory = 100 x 4
Value of Inventory = £400
Now imagine that you only sold 125 candles. That would mean you’d have 100 of November’s left over, but only 25 of October’s. In this instance, the calculation would look like this:
Value of Inventory = (100 x 4) + ( 25 x 5)
Value of Inventory = £525
When is the FIFO Inventory Valuation Method useful?
FIFO is a particularly good method to use if you’re selling food items or other time-sensitive goods. The assumption that goods bought first will sell first is quite accurate in this case, as you’ll want to be selling items before they literally become unsellable.
Furthermore, the FIFO method is widely seen to be accurate as you’re more likely to input the actual price of goods because there will be less time for the purchase price of goods to change.
For this reason, it’s favoured by many government taxation departments across the world.
Inventory Valuation Method 2: Last-In, First-Out
The LIFO method is essentially the FIFO method but reversed. This method assumes that you sell your newest items first, rather than after your older inventory on your balance sheet. So, under LIFO, the method would look like this:
Value of Inventory = Number of Oldest Remaining Units x Purchase Cost
Taking the same candle business example, let’s imagine you sold 200 units. You would have 50 units left, but rather than using 50 units from November’s order, you’d take the 50 units from September:
Value of Inventory = 50 x 3
Value of Inventory = £150
Using an alternative method massively showcases how different results can be depending on the method used. For example, if we’d calculated the above using the FIFO method, the value of inventory would be £200, rather than £150.
When is the LIFO Inventory Valuation Method useful?
LIFO is used less frequently than FIFO as it’s seen to be less useful and accurate in most situations. Similarly, many countries outside the US don’t allow for the LIFO method to be used in most situations, due to the International Financial Reporting Standards(IFRS).
It can only be used in the US because the US adheres to Generally Accepted Accounting Principles (GAAP). That being said, LIFO does have its uses.
It’s more appealing in times of high inflation, or used for items that are impacted the most by inflation. Businesses that sell products have consistently rising prices each year will benefit from using LIFO as they will pay lower tax.
Inventory Valuation Method 3: Weighted Average Cost
Using this inventory valuation method, we work out our inventory value by taking the average cost of our goods over a specific period of time. It’s probably the simplest method, and isn’t really accurate unless you sell a lot of similarly priced items, like t-shirts, for example.
Here’s the method:
Weighted Average Cost = Cost of Goods Sold / Number of items bought in a period
Let’s return one final time to our candle business. We’ve sold 150 candles, and we’re using the FIFO method to calculate the Costs of Goods Sold (COGS). In this case, COGS = £650 (3 x 50) + (100 x 5 ).
Then, we’ll simply divide 650 by the number of units bought from the supplier over that three month period, which, in this case, is 250. Therefore, the final methodology is:
Weighted Average Cost = 650 / 250
Weighted Average Cost per unit = £2.60
To get a total inventory valuation, we can time 2.6 by the unsold number of units, which, in this case, is 100. Therefore, Value of Inventory = £260
When is the Weighted Average Cost Method useful?
As mentioned above, the weighted average cost method is only really accurate when you sell a lot of products at a similar price. The bigger price differences you have, the less accurate this method is going to be.
While you won’t be able to use this method for tax purposes, it’s a helpful method to use for effective inventory management.
As one of the simplest inventory valuation methods, you’ll only need to perform one calculation for your entire stock. Furthermore, the method helps you to manage inventory or stock better as it’ll help you price accordingly across the board.
3 Challenges you may face to value inventory
Valuing inventory can be a complex task, presenting various challenges that businesses may encounter. Let’s explore some of the common hurdles faced when assessing the value of inventory.
-
Large Quantities
Dealing with substantial inventory volumes can pose significant challenges. Managing and accurately valuing large quantities of goods requires robust systems and processes to ensure consistency and accuracy.
Without proper controls in place, errors in counting, recording and valuing inventory can occur, leading to discrepancies in financial statements and potentially impacting business operations.
-
Inventory Distributed Geographically
For businesses with inventory spread across multiple locations or regions, valuation becomes even more challenging. Coordinating inventory counts, reconciling data and ensuring uniform valuation practices across different locations can be daunting.
Additionally, variations in local market conditions, currency fluctuations and regulatory requirements add complexity to the valuation process, making it challenging to arrive at a consistent and accurate valuation of inventory.
-
Inventory Auditing
Conducting inventory audits presents its own set of challenges. Auditors need to verify the existence, quantity and condition of inventory items, often requiring physical inspections and reconciliations with accounting records.
Coordinating audits across multiple locations, especially if they are geographically dispersed, can be time-consuming and resource-intensive. Moreover, ensuring compliance with auditing standards and regulations adds another layer of complexity to the process.
Improve your inventory management techniques with J&J Global Fulfilment
We hope this article has proven useful; we know that managing costs can be a minefield for eCommerce businesses, especially those who are experiencing rapid growth in a short amount of time.
At J&J, we understand how tedious inventory management can be, which is why we’ve developed software in-house to significantly speed up the process. Our award-winning software, ControlPort™, makes inventory management a breeze, presenting you with data from all of your channels in an accessible, accurate, and digestible format.
Want to learn more about our fulfilment service and software? Don’t hesitate to get in touch.
About the Author
