Any business that produces and sells a product, or physical goods has inventory to one extant or another. It is one of their biggest physical assets and it has a significant effect on the profit a company generates, tax liabilities and the value of the specific asset.
Now when we talk about inventory the term isn’t universally equal to all businesses. For example, a business may sell computers but not actually manufacture or produce them. While a company who makes ketchup and sells it has quite a few more considerations when it comes to inventory. The computer seller needs to perhaps account for the number of computers they have in inventory, when they were purchased, sold and at what costs. While the ketchup producer has raw goods to account for, finished goods, multiple packaging types, labels, and more. Also do they create the packaging themselves? If that is the case, then the raw materials for that also is considered inventory.
In the end both companies to account for the value of their inventory. That’s where inventory valuation comes in. This is the accounting process of assigning a value to inventory and doing so in a measurable and consistent manner. This helps with the overall profitability of the business as well as keeping clear financial statements.
There are a few ways companies keep track of inventory valuation. There is the First In, First Out (FIFO) method which values inventory as though the first inventory items purchased are the first to be sold. The Weighted Average Cost (WAC) method is based on the average cost of items purchased.
The method chosen has a direct impact on gross profit during an accounting period. This doesn’t mean that a company that uses FIFO must sell product that’s older before moving newer ones. This is purely an accounting decision and how they will value their inventory.
The method that a company uses to value its inventory has a direct correlation to the cost of goods sold (COGS), gross income and monetary value of the assets leftover at the end of the period.
It’s also important that a company choose a method of valuation because consistency is important, especially for government tax bureaus. For example, the IRS requires a company to stick to one method for at least the first year of operation. Even then the IRS requires that the company gain permission before switching methods so that there are no irregularities in reporting taxable income.
With any type of inventory there are costs associated with it. Those costs need to be accounted for in the inventory valuation process. If we use our ketchup producer example, inventory exists in the form of raw materials and finished goods. To make that bottle of ketchup someone needs to work to produce it though. This is part of the direct labor overhead costs of producing the ketchup. Inventory valuation takes all of these into consideration.
These associated costs are things like direct materials, which also includes anything that was wasted or damaged. Production overhead, which is anything not related to the direct production, like office worker salaries, rent, utilities, maintenance costs, etc. Freight in, which are any transportation costs associated to the goods. Handling, which are costs associated to preparing goods for shipment; picking of inventory, packing, shipping labels and loading onto trucks out of the warehouse. Finally, there are duties where applicable by governments. There are others depending on the business, but these are some of the most common.
All of this makes for unique challenges when it comes to inventory valuation. There are two in particular: determining the total cost of inventory, and directly related, how much inventory they have. Easy right?
Goods are constantly fluctuating in price. Tomatoes for our ketchup producer might be one price during a specific quarter, but then rise the next. Maybe weather caused a lower harvest from a key supplier. Inflation also is inevitable. A dollar today doesn’t buy what it did yesterday the saying goes. As for how much of what you have this can be tricky. Do you count goods that are in transit? Held up at a border? Or can you accurately determine exactly what is in stock in your warehouse this very day? All important considerations.
As for which method a company would use for inventory valuation it all depends on what suits them best as well as how they use their inventory. The four main ones are:
• First In, First Out (FIFO)
• Last In, First Out (LIFO)
• Weighted Average Cost (WAC)
• Specific Identification (no fancy acronym required)
Each has its own set of advantages and slight drawbacks from an inventory valuation perspective. These drawbacks usually are specific to how much revenue is being reported, and how much tax will be paid. Although, aggregated over time everything evens out. There’s no hard and fast rule for which method you should choose but here is the summary of each method:
FIFO tends to produce the highest gross income during the current period, LIFO the lowest, and WAC something in between. Of course, FIFO generates the highest taxes and LIFO the lowest, with WAC again, right in the middle. One advantage of LIFO is that it matches recent revenues with recent costs, minimizing the effects of inflation or deflation. Specific ID is the natural method when you or your customers want to know the cost as well as the selling price of every unit.
Inventory valuation can be complex especially once a business starts to take off and grow. With the help of financial software and WMS systems it can take away much of the headaches. For example, with Akatia’s WAM WMS businesses can account for which method they want to use, track the cost of goods, if they’re enroute or in stock and apply any associated costs like shipping fees to the inventory.
There’s a lot to consider when it comes to inventory valuation but the importance to business and warehousing is crucial. Evaluating your business and choosing the best method for you and sticking with it is certainly part of the process. Yet the way forward doesn’t have to be hard or aggravating. By using WMS solutions like Akatia’s WAM you can increase accuracy and alleviate much of the burden for staff so that they can concentrate on more valuable tasks that are important to your business.