Managing your inventory is key for predicting demand and budgeting for future stock value.

When businesses don’t succeed in inventory management, they will contribute to the $1.1 trillion loss worldwide. This is due to overstocked items and products that haven’t been compared against the newest valued trends.

The value of your inventory can change over time, so it’s important to keep track of new and old items. You can do this by following one of the several accounting methods. Just keep reading to find out what these methods are!

What Is Inventory Valuation?

Inventory valuation is a type of accounting practice that determines the value of any unsold stock. A business can use several methods when finalising financial statements. For example, they might use a balance sheet to record the current total value of their inventory cost at the end of each year.

Why Is Valuing Your Inventory Important?

Understanding the value of unsold items is important for maximising your business’ profits, tax liability and asset value in the future. Prices fluctuate throughout the year for different products, so you need to find a common rate for calculating unsold inventory.

Not valuing your inventory can lead to inflating net income. This is because you have overstated the cost of goods sold. To maintain high inventory value, always use the correct method during your chosen accounting period.

It’s also essential that you stick to your chosen inventory valuation method. The Australian IRS will require businesses to commit to one method during year one of filing taxes. You can always ask for permission to change if you’re not happy with the inventory valuation technique.

The Top 4 Inventory Accounting Methods

There are four main inventory accounting methods that can help you finalise any financial statements. You can choose a method based on your inventory, cost of goods sold, and other inventory purchases made throughout the year. It’s important to determine your inventory accounting method in advance to prevent a false income statement.

Here are the 4 types of inventory valuation methods:

1.    First-in, first-out (FIFO)

First-in, first-out (FIFO) is the most common inventory accounting method. The first items purchased are usually the first to leave your warehouse. Any products held in the warehouse for the longest duration take top priority during sales.

FIFO is mainly used for cost flow assumption purposes. This means the cost of inventory items will change from when they were purchased and sold. Due to the cost differential, you’ll need an inventory management system for assigning costs to sellable products.

To navigate this inventory valuation method, determine the cost of your longest-holding inventory. Then, multiply that total cost by the amount of inventory sold. Of course, prices fluctuate over the year, so take that into account as well.

For example:

Steve owns a shoe business and orders his shoes for $15 per unit. He has 200 units in his inventory at the beginning of June. During the middle of June, the price of the units goes up to $20. Steve buys an additional 100 pairs of shoes for $15 per unit and 150 pairs of shoes for $20 per unit.

By the end of June, Steve sold 350 pairs of shoes. Using FIFO, the $15 per unit of shoes were sold first. His cost of goods sold works out to be $5500. Since the older inventory went first, he has to calculate the remaining 100 that cost $20 per unit. His ending inventory would be $2000 for the month of June.

Number of items left x highest unit value = FIFO inventory cost

2.    Last-in, first-out (LIFO)

Last-in, first-out (LIFO) means your most recent products in the inventory are sold first. How much you spent on those items will determine the numbers on your balance sheet. This method is essentially the opposite of FIFO in terms of inventory management.

A business might use LIFO when production and inventory costs increase quickly. Common reasons comprise inflation, customer demands and purchase of raw materials. Even though this method decreases business profits, it can still contribute to less corporate tax over the year.

You can use the same formula as the FIFO, but determine costs of your highest inventory costs first.

For example:

Lisa purchased 100 hats for her business costing $30 per unit. The next day, she purchased 200 additional hats for $40 per unit. Based on the last-in, first-out method, the more expensive units will be sold first. In total, 250 hats are sold, so how do you calculate the costs?

Since the $40 per unit hats are all gone, Lisa will need to calculate the remaining price for the items purchased beforehand. In total, the costs add up to $9500. To put it straight – 200 hats for $40 and 50 hats for $30.

Her ending inventory cost would be $1500. During price increases in the market, LIFO lowers net income and reduces tax.

Number of items left x lowest unit value = LIFO inventory cost

3.    Weighted average cost (WAC)

The weighted average cost method (WAC) refers to the inventory’s average cost throughout the year or accounting period. It is common for businesses to pay different prices when certain stocks are not available. You can use this method to determine the overall cost related to inventory and the cost of goods sold.

For example, Michael has purchased the following units:

Date	Number of items	Cost per unit	Total
01/01	30	$40	$1200
01/24	50	$45	$2250
02/11	40	$50	$2000
02/29	20	$70	$1400
03/10	35	$85	$2975
Total	175		$9825

Let’s assume that Michael sold 160 items. Start by calculating $9982 ÷ 175 inventory units. This will produce an average figure of $57.04 per unit. The weighted average cost of goods will show as 160 items sold x $57.04 average cost = $9126.40.

Now, to calculate the remaining inventory for sale at the end of an accounting period, you’ll multiply the final 15 items by $57.04 to get $855.60.

The weighted average cost method requires minimal labour and paperwork. Businesses that sell indistinguishable products may prefer to use this method when determining the cost of goods sold.

Total Cost of Goods Purchased or Produced in Period / Total Number of Items Purchased or Produced in Period = Average Cost for Period

4.    Specific identification method (SE)

The specific identification method (SE) tracks every single item in your inventory from the time you purchase it until the time it’s sold. Businesses that sell unique items or non-bulk products may use the specific identification method to keep accurate inventory costs.

You can also use SE to identify separate items using their scannable bar code, RFID tag, receipt and unique serial number.

For example:

A car dealership has 80 cars. Each car comes with a unique dealer, cost, and sale price associated with the trending model. The business would track when the car enters the lot until it is sold. Essentially, the owner has an incoming stream of information when it comes to popularity with customers and average pricing rates.

No other inventory costing methods can provide the same level of accuracy as the specific identification method. You can monitor individual products throughout the whole accounting period as well.

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A Quick Summary

There are certain inventory valuation methods that suit every business. From counting beginning inventory to the cost of goods sold, you’ll find a method that applies to your balance sheet.

For example, retail businesses might use FIFO to get rid of unsold inventory. This is a good way of preparing for cost flow assumptions that expand their profit margin.

If you need better management with warehouse storage, eCommerce Shipping has got you covered. We praise seamless logistics, order management and order tracking when it comes to inventory. You don’t have to worry about how much inventory you have left or how to adjust to the cost flow assumption.

Contact us today if you’re interested in managing inventory costing more efficiently.

FAQs

Here are some frequently asked questions about inventory costing methods:

Why is inventory valuation used?

Inventory valuation methods are used to find out the inventory value of your unsold stock. You can do this when preparing financial statements and recording numbers on the balance sheet. Businesses need inventory valuation methods to maximise profitability and predict the cost of goods sold in the future.

What are the three benefits of FIFO?

Some of the benefits of FIFO include increased warehouse space, warranty control and minimal stock handling. This is because you’re selling items that are close to the expiration date first, meaning they don’t require extra storage space. As for stock handling, traditional rack systems push the older items to the front of the queue.

What is the best method for inventory valuation?

The first-in, first-out (FIFO) method works best for most businesses. It is a common inventory accounting technique for retailers looking to evaluate the cost of goods sold.

When deciding on a method, consider talking with an accountant or tax expert to gain their opinion. Inventory costing methods all work differently for each business and its products.