As a business owner, determining whether your business has performed as per expectations or not is critical. It dictates your business practices and operations in the future and allows you to adjust for better outcomes. To that end, you must calculate the costs of running your enterprise. A significant portion of your expenses is incurred on inventory. This is where inventory valuation comes into play and can be of immense help. Continue reading to learn more about inventory valuation and how it can benefit your business.
What is inventory valuation?
Your inventory is an essential current asset on your balance sheet that significantly impacts your business’ profits. Inventory valuation determines the costs associated with the goods your company sells. It also helps gauge the value of unsold goods lying in storage.
Essentially, inventory valuation is a way to assess the worth of unsold inventory items while preparing your company’s financial statements. You must value such inventory appropriately at the end of the reporting period, like the financial year.
Inventory valuation is based on the costs of inventory acquisition, conversion to saleable items, and transportation. It does not include any administrative or selling costs and consists of the expenses of direct labour, materials, factory overhead, import duties, etc.
What are the methods used for inventory valuation?
The most popularly used cost-flow inventory valuation methods are given below:
Specific identification method: This method is used to track the specific cost of individual items of inventory. It is handy when inventory items are unique, for instance, in an art gallery.
First In, First Out Method (FIFO method): It is used when the first items to enter the inventory will also be the first ones to be used. Thus, the costs of the oldest inventory items are charged to the cost of the goods sold first. If there is a period of price inflation, the cost of goods sold (COGS) will tend to be low, resulting in higher reporting profit and increased income taxes.
Last In, First Out Method (LIFO method): This method is used when the inventory items purchased last are also the first ones to be used. While this method implies that older items are kept in stock, this is not the case. However, this method is frequently used because it charges the most recent costs to the costs of goods sold. Thus, in a period of price inflation, it reduces profits and the amount of income taxes to be paid.
Weighted Average Cost Method: This method applies an average of the costs in inventory to the goods sold. Thus, it means that the cost of goods sold will neither be excessively high nor low during a period of price inflation. This method is representative of the actual cost of items stored in inventory.
Why is Inventory Valuation Important for your Business?
Inventory valuation is an essential tool and can impact the following aspects of your business:
Cost of goods sold: If your ending inventory is valued high, there will be less expense left to be charged to the costs of goods sold, and vice versa. Thus, inventory valuation has a huge impact on reported profits.
Multiple periods: If your inventory valuation is incorrect, the reported profits for two consecutive periods will also be wrong.
Loan ratios: Suppose you have taken a loan for your business and cannot meet the restrictive ratio placed on the proportions of current assets to current liabilities. In such cases, the lender can call the loan. Since inventory is usually the most significant contributor to this ratio, you must evaluate the same.
Income taxes: By using the correct cash-flow method, you can reduce the income tax you must pay.
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Read more about the cash flow statements here.
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