Understanding Inventory Valuations

Inventory is defined as an item held for sale, and inventory can be purchased or produced internally. Manufacturers, retailers, and wholesalers stock inventory, and inventory may require a large capital investment. For that reason, managing inventory has a big impact on cash flow, business profit, and the tax liability owed to the IRS. 

If you carry inventory, a large amount of the accounts payable balance may be inventory-related purchases. Stampli’s AP Automation brings together accounts payable communications, documentation, corporate credit cards, and ACH or check payments all in one place, allowing AP to have full control and visibility over corporate spending.                                                                                                                                                                                           

Inventory accounting can have a big impact on the financial statements, including the income statement and balance sheet. As this podcast episode explains, managing inventory effectively allows the business to scale.

Connecting to the Financial Statements

Inventory is a current asset in the balance sheet, meaning an asset that will be converted into cash within a year. If a business manufactures and holds inventory for resale, generally accepted accounting principles (GAAP) include raw materials and other costs as inventory. Retailers that purchase inventory record the purchase price as the inventory cost. 

Assets can be valued based on cost, market value, or the lower of cost or market. A business owner can use different inventory valuation methods, including the specific identification method and net realizable value. The cost of an asset impacts gross profit, the profit margin on the sale, and net income.

To manage inventory effectively, you need to understand how an inventory item is valued. Inventory management for most companies, including small businesses, involves using one of the three inventory valuation methods: 

• First in first out (FIFO) method

• Last in first out (LIFO cost) method

• Weighted average cost method

Before choosing a method of inventory valuation, it’s important to remember that some inventory information is the same, regardless of the accounting methods you choose. 

Reviewing an Example

To explain valuing inventory using the three methods, assume that Courtside Sporting Goods purchases baseball hats into inventory. Beginning hat inventory for the month of September is zero, and Courtside makes these purchases and sales during October:

The information is the same for each valuation method. Specifically, the $5,850 total dollars spent, 325 units purchased, and the number of units sold (100 units) do not change. An inventory valuation method determines the timing of costs during an accounting period. When an item is sold, which price is used to determine the cost of the unit? The answer depends on the method you select for the value of the inventory.

Using the first in, first out (FIFO) method

As the name implies, the FIFO method assumes that the oldest inventory items are sold first. 

Another factor that impacts the cost of inventory is inflation, which is defined as an increase in prices over time. The items purchased on 10/1 are less expensive than purchases on 10/17. This discussion assumes that inflation is increasing prices over time, so that the older items sold are less expensive, and this concept applies to each cost flow assumption.

If you choose the FIFO method, this is the calculation of cost of goods sold (COGS):

Courtside’s first purchase was 100 units at $15/unit. The FIFO method assumes that the oldest units are sold first, which is all 100 units at $15.

Inventory items are accounted for in one of two places: cost of goods sold or ending inventory. After calculating the cost of goods sold, all remaining items purchased make up the ending inventory balance. Courtside’s ending inventory balance includes the items purchased later in the month:

The total cost to account for is the sum of cost of goods sold and remaining inventory at month end. In this case, the cost of goods sold is $1,500, ending inventory is $4,350, and the total cost to account for is ($1,500 + $4,350), or $5,850. 

When using the LIFO method, you start with the oldest units first. The LIFO method, on the other hand, starts with the newest (more expensive) units.

Applying the Last In, First Out (LIFO) Method

LIFO uses the same units purchased and units sold data presented above, and you use the chart to compute cost of goods sold and ending inventory. Here is the cost of goods sold information:

Using LIFO, the newest units ($22) are sold first, with 50 units sold on 10/25, and 25 units sold on 10/31. The last 25 units sold are assigned a cost of $18 per unit. Here is the ending inventory calculation:

The 125 units at $18 remain in ending inventory, along with all 100 units purchased at $15. 

The total cost to account for is the sum of cost of goods sold and remaining inventory at month end. In this case, the cost of goods sold is $2,100, ending inventory is $3,750, and the total cost to account for is ($2,100 + $3,750), or $5,850. 

The weighted average method is the easiest method to calculate.

Deciding on the Weighted Average Method

The weighted average cost is ($5,850 total cost / 325 units purchased), which is $18 per unit. To use this method, apply the cost per unit to the cost of goods sold and ending inventory:

Each of the inventory valuation methods generate a different profit for units sold.

Calculating Profit Using Each Method

Let’s assume that the selling price for 100 units is $30/unit, and compute the profit using each inventory valuation method:

FIFO has the lowest cost of goods sold, because the oldest units are sold first, and this generates the higher level of profit ($1,500). Since LIFO sells the newest units first, the cost of goods sold is higher, and the profit is lower ($900). Finally, the weighted average method generates a profit level between FIFO and LIFO ($1,200).

As mentioned above, inventory valuation methods differ based on the timing of costs. FIFO assumes that the more expensive items will be sold later, generating a lower profit in future periods. LIFO sells less expensive items in future periods, and produces a higher profit.

All three methods generate the same total profit when all 325 units are sold, and the difference is only in the timing. For these reasons, accounting standards require companies to select an inventory valuation method and to use it consistently. If not, the cost and profit on inventory sales will be misleading. 

Accounting for inventory purchases can be time consuming, and AP Automation can help you save time and reduce errors.

Take Control of Inventory Purchases

Stampli’s end-to-end platform gives you full control and visibility over all your corporate spending from card to invoices to payments– all in one place. Take control over invoice and bill processing with smart, intuitive, and actionable AP Automation software. 

Managing inventory requires accurate data, and may require a large capital investment. Take control of your inventory purchases with Stampli.