Are you a manufacturer? If the answer is yes, then inventory is the finished product you produce. Are you a retailer? If you are, then inventory is the product you buy for resale in your store. Do you sell a service and not a product? If you do, then you don’t have inventory. For small businesses that sell a product, you would not be in business without an inventory of that product on your shelves. But, how do you know the value of your inventory?
The four main inventory valuation methods are FIFO or First-In, First-Out; LIFO or Last-In, First-Out; Specific Identification; and Weighted Average Cost. We'll dive deeper into these – but first, let's go over some basics.
Is Inventory an Asset?
There is an easy way to think about inventory to answer this question. Anything that your business owns is an asset. Anything that your business owes is a liability. Inventory is always an asset. You own your inventory. Inventory is sometimes a vulnerability, but it is always also an asset.
The Financial Accounting Standards Board (FASB) developed a set of rules, standards, and conventions called the Generally Accepted Accounting Principles (GAAP), in which inventory is not only an asset – it is a current asset.
What is a Current Asset?
A current asset is something your business owns that has a short-term life. Current assets are utilized and mature in one year or less. Current assets are your firm’s liquid assets and are listed on the left side of your balance sheet in the order of their liquidity. Liquidity refers to the speed with which an asset account can be converted to cash.
Cash is your firm’s only perfectly liquid account since it obviously doesn’t have to be converted. If your business has any short-term investments, with maturities of less than one year, those are listed second as marketable securities. The third most liquid current asset account is accounts receivable. Accounts receivable are your credit accounts or what your customers owe you. Last, under current assets, is inventory.
Inventory is the least liquid current asset. It is the hardest to convert to cash because you have to find a buyer for that inventory.
At the bottom of the left side of your business’s balance sheet are your fixed assets. As compared to current assets, fixed assets are not very liquid and have a life of one year or longer. Included in this balance sheet entry are the business’s property, plant, and equipment.
Issues with Inventory
Despite what the GAAP principles say, some business owners or managers feel that inventory can be a liability. However, since inventory is an asset in all situations, business owners should think about the problems they have with inventory as vulnerabilities instead of liabilities since the word “liability” is an important accounting term.
Liabilities on your balance sheet represent what you owe. They include both short-term debt, in the form of accounts payable and accruals, and long-term debt, such as mortgages.
Sometimes, inventory can feel like a liability, but it is actually a vulnerability. If a business owner miscalculates the inventory it needs, then the firm may either stock out or hold on to too much inventory until it becomes obsolete. Both will cut into your profitability. Stockouts cause the loss of customer goodwill and sales will drop. Overstock is nothing more than wasted inventory. Good inventory management will mitigate both issues.
Inventory Management and Valuing Your Inventory
Inventory management is one of the most important tasks that a business owner can do to ensure the success of the business. That’s because not only is inventory an asset, but it is usually the current asset with the most value that firms who produce or sell a product have on their balance sheet. Good inventory management is the process of ordering, storing, and selling your inventory. Inventory has three components — raw materials, work in progress, and finished goods. You also have to warehouse and process your items of inventory.
Inventory valuation, also called inventory accounting, is the process of determining how much your inventory is worth to your business at the end of every accounting period. An accounting period is usually either a year or a quarter. Inventory costing methods allow you to find the value of your inventory for the purposes of your financial statements, the effect on the cost of goods sold (COGS) with the different valuation methods, and the effect on overall firm profitability.
Inventory Valuation Methods
A business’s balance sheet reflects the value of its inventory, but where does that value come from?
As we mentioned earlier, there are four main inventory valuation methods: FIFO or First-In First-Out; LIFO or Last-In First-Out; Specific Identification; and Weighted Average Cost.
The Internal Revenue Service only allows you to choose between FIFO, LIFO and Specific Identification for valuing inventory on your taxes, though other valuation methods could be useful in different circumstances. For example, if you’re creating an annual report for shareholders, you might choose the inventory valuation method that shows the highest net income.
Let’s take a deeper look at all four inventory valuation methods, so you can choose what’s best for your business.
1. First-In, First-Out (FIFO)
The First-In, First-Out, or FIFO method of determining inventory value allows you to assume that the first inventory items you stock your business with are the first inventory items you sell. Here’s an example of FIFO:
Masks and More, Inc. sells custom-designed facial coverings. They bought:
- 200 masks in April at $2
- 200 masks in May at $3
- 100 masks in June at $4
That’s a total of 500 masks they bought, and 300 masks sold during the year. If you were developing the company’s balance sheet at the end of the year, what value would you enter for inventory if you use FIFO?
We can work this out as follows. Under FIFO, you sell the oldest inventory first. The beginning inventory — the 200 items you purchased in April — are sold plus the first 100 in May for a total of 300 items sold. If 300 items were sold, 200 are still in inventory.
In order to value your inventory using FIFO for the company’s balance sheet, you multiply the 100 items that are left from your May purchase by the $3 you paid to purchase them. You add that to the 100 items left that you bought in June times the $4 you spent to purchase them.
Value of Inventory Under FIFO = (Units of Newest Inventory x Value) + (Units of any other Newer and Remaining Inventory x Value)
Value of Inventory Under FIFO = (100 X $4) + (100 X $3) = $700
We can also calculate the cost of goods sold (COGS) if FIFO is the inventory accounting method. You sold 300 of the 500 units of inventory you had in stock.
COGS = (Number of Items Sold First x Value) + (Number of Items Sold Next x Value)...until you factor all items sold
COGS = (200 X $2) + (100 X $3) = $700
2. Last-In, First-Out (LIFO)
Under Last-In, First-Out, or LIFO, which is the opposite of FIFO, you sell the newest items first. We can work this out as follows. The amount sold is 300 out of 500 masks purchased. So the last items you purchased in May and June are sold. If 300 items were sold, 200 are still in inventory — the first 200 purchased in April at $2. To find your cost of inventory here, you multiply the oldest and remaining inventory — the 200 items that were first purchased in April — by the $2 purchase price.
Value of Inventory Under LIFO = Oldest and Remaining Units of Inventory x Value
Value of Inventory Under LIFO = (200 X $2) = $400
Since the value of the inventory is $700 under FIFO and $400 under LIFO, obviously different inventory valuation methods make a huge difference on the company’s balance sheet for the inventory line item.
If we calculate COGS with LIFO here, 300 units of inventory were sold, which were the last 300 masks purchased. Out of that number, 200 were purchased in May at $3 per unit. 100 were purchased in June at $4 per unit. Here is the equation:
COGS = (Number of Items Sold First x Value) + (Number of Items Sold Next x Value)...until you factor all items sold
COGS = (200 X $3) + (100 X $4) = $1000
So, you can see different inventory valuation methods yield different results. In this example, COGS is significantly higher under LIFO than under FIFO, making the profit margin larger.
3. Specific Identification Method
The specific identification method of inventory valuation is useful for businesses with a low turnover of high-cost items like automobile dealers, furniture stores, and jewelry stores. Specific identification involves tagging every item in inventory with its purchase price and any associated costs since it was purchased. Then, the value of all the remaining inventory in stock is added up to get the total cost of the company’s inventory. Specific identification gives the business owner very accurate information on the value of their inventory.
4. Weighted Average Cost Method
The Weighted Average Cost Method is used when companies don’t have major changes in their inventory. It finds the average of all the units bought during a period of time. The equation for weighted average cost is:
Weighted Average Cost = COGS/Total Number of Units Available Over a Period of Time
Let’s assume we’ve still sold 300 of our 500 masks, and we’re using our last example (where we used the LIFO method). That put our COGS at $1000. Now we just divide that by our total units (500).
Weighted Average Cost = $1000/500 units = $2
So, our weighted average cost per unit is $2.
Note: Unlike the other three inventory valuation methods, the Weighted Average Cost Method is not allowed by the IRS for tax purposes (but remember, that doesn’t mean you can’t use it for other financial statements or accounting purposes at your company).
What Do Businesses Most Often Use?
FIFO is the method most often used by businesses because the lower cost of goods sold reduces the company’s tax liability. FIFO will also help the problem of overstocking have less effect on the business. The other methods, however, can be useful in certain circumstances. For example, if you’re creating an annual report for shareholders, you might choose the inventory valuation method that shows the highest net income or gross profits.
Have a Firm Grasp on All Things Inventory
Since inventory is the largest current asset in value, it can also be the most difficult to deal with. To create a sound inventory system, you must understand how it is used when developing the required financial statements for your business and how it is valued. Other important areas to have a firm grasp of are overall inventory management, inventory turnover, how much inventory to order and the ordering costs, how often to place an order, the costs of carrying inventory, economic order quantity, and the use of just in time inventory management.
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