What Is Inventory Valuation and Why Is It Important?

what is inventory valuation

Inventory valuation is the monetary sum related to the inventory’s goods toward the end of an accounting period. The valuation depends on the expenses brought about to obtain the stock and prepare it for purchase. 

Inventories are the most significant current business resources. Valuation of inventory permits you to assess your Cost of Goods Sold (COGS) and your productivity. 

Techniques for valuation are:

  • FIFO method (first-in, first-out)
  • LIFO method (toward the end in, first-out) 
  • WAC method (weighted average expense) 

This article covers: 

What Are the Objectives of Inventory Valuation? 

Inventory points to the goods both for sale and those not for sale. It includes raw materials, processed and unprocessed goods. Inventory valuation is done toward each financial year’s finish to figure the expense of products sold and the expense of the unsold inventory. 

It is important, as the abundance or lack of inventory influences productivity and profit. 

The objectives of Inventory Valuation are as follows:

Decide The Gross Income 

Inventory determines the gross profit of a business. We can calculate it as the excess of the sales over the expense of goods sold. 

To determine the gross profit, the cost of products coordinates with the accounting period revenue.

The equation for calculating gross profit is:

Cost of merchandise sold = Opening stock + Purchases – Closing stock 

The equation shows that the inventory value influences the expense and, accordingly, the gross profit. 

For instance, if the closing stock value is high, it will increase the current year’s profit and lower the resulting years’ profits. 

Find Out The Financial Position 

Closing stock appears as a current resource. The estimation of the closing stock on the Balance Sheet decides the monetary situation of the business. High valuation or devaluation can mislead about the working capital position and financial condition. 

How Inventory Is Valued ?

The technique for valuing inventory relies upon how the business follows the stock efficiently. A company should value cost of inventory. The cost of merchandise is consistently changing due to selling and restocking. It should assume the frequent use of cash flow. 

There are four methods for inventory valuation. These are: 

  • specific Identification 
  • First-In, First-Out (FIFO) 
  • Toward the end In, First-Out (LIFO) 
  • Weighted Average Cost 

Specific Identification 

This method of inventory involves the tracking of goods from stocking until the sale. It typically utilizes larger items with different features and their costs.

The basic requirement of this strategy is the tracking of each item with an RFID tag, a receipt with the stamp, date, or serial number. 

This strategy ensures a high-level of accuracy to inventory valuation; it confines to valuing unusual, high-value items for which differentiation is compulsory. 

First-in, First-out (FIFO) 

This technique depends on the principle that the first inventory bought is the first to be sold. Recently purchased or produced resources are tend to match up with the leftover resources. It is one of the easy-going methods that any business can follow easily. 

During the inflation period, the FIFO strategy yields a higher value of :

  • the closure inventory 
  • lower cost of goods sold
  • a higher gross profit. 

Drawbacks:

  • Do not introduce accurate information of the costs when there is an inflation in prices. 
  • In contrast to the LIFO technique, it doesn’t offer tax benefits. 

Last In, First-out (LIFO) 

This strategy works on the principle that the latest inventory sells first while the older list stays in stock. Most businesses do not use this strategy to prevent any significant loss.

The possible motivation to utilize LIFO is when organizations expect the inventory cost to increase over time and lead to a value expansion. 

By moving significant expense inventories to the cost of products sold, it lowers the profit level of businesses. It ultimately lowers the taxes for businesses.

Weighted Average Cost 

Under the weighted average cost strategy, the weighted average utilizes to decide the amount that goes into the expense of goods sold and inventory. 

We can use the following equation to calculate weighted average costs:

Weighted Average Cost Per Unit = Total Cost of Goods in Inventory/Total Units in           Inventory 

This technique utilizes to determine an expense for indistinguishable units, and it is hard to follow the individual costs. 

Which Inventory Valuation Method Is Best?

Picking the correct inventory valuation technique is important as it directly affects the business’ overall revenue.

There are pros and cons to every technique. For instance, the LIFO strategy will give you the least benefit because the last inventory items purchased are generally the most costly. In contrast, the FIFO will provide you with the highest profit as the first stock items are usually the least expensive. 

Focus only on inventory costs to choose the best method for your business.

Here I will give you insight into different conditions in which you can choose the best suitable method:

  • If the inventory costs are rising or are probably going to expand, LIFO costing might be better. As expensive items markup as sold, it brings about inflated prices and lower profits. 
  • In case if your inventory costs are falling, FIFO may be the ideal alternative for you. 
  • For a more exact cost, utilize the FIFO technique for inventory valuation as it accepts that the older items that are less expensive tend to sell first. 

As an entrepreneur, you need to examine every strategy and apply the technique that shows the periodic income accurately and suits your particular business situation. 

The Financial Accounting Standards Board (FASB) permits FIFO and LIFO accounting in GAAP( Generally Accepted Accounting Procedures). 

It is to note that organizations can’t change, starting with one inventory valuation technique then onto the next.

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