- What is inventory valuation?
- What is the difference between FIFO and LIFO?
- How do you calculate FIFO and LIFO?
- Which method is better, FIFO or LIFO?
- Is LIFO allowed under GAAP?
- Which is the best inventory valuation method for your business?
Accounting is not merely about recording the financial transactions of a company or individual. It also provides us information that can be analyzed to study trends and patterns in financial behaviors and patterns. A company that uses this mine of data to drive decision-making will be at a great business advantage.
Improving the bottom line and profit margins is one of the primary goals of a business. Expenses must be curtailed and revenue increased to keep the cash register happily ringing. One of the main outflows in a business is the money spent on purchases. At the same time, the purchase process is also what drives the activities of the company. For a manufacturing company, the purchase of materials feeds the manufacturing process. In retail, stocking the right inventory in the right quantity drives sales and revenue. So understanding purchasing, inventory, and inventory valuation are vital to the financial success of a company. Inventory valuation techniques help you better assess your inventory.
What is inventory valuation?
When a company prepares its financial statements, it will have to list in detail all the assets owned. The assets include the inventory that is being held. So, the value of the inventory has to be correctly calculated in order to list it on the financial statements. Inventory valuation also helps you study the inventory turnover trends and ratio. This helps the company plan its purchase and inventory decisions. So, inventory valuation tells you the value of the inventory that you are carrying at the end of the financial period.
In this part of the article, we shall learn how the different methods yield varied results and how they affect your purchasing decisions. Moreover, inventory valuation is a great way to understand why you must have a grip over inventory management.
The importance of inventory valuation
To calculate the value of your inventory, you need to first count how many/much you have of each inventory item. The next step is to determine the value of the items that you have and multiply it by the number of items that you have. This may not be as simple as it appears to be because the same items may have been purchased at different times and at different rates. The fluctuation of the rates of the items purchased will reflect on the total value of the inventory. The final value of the inventory being held is then consolidated from these separate values.
Three types of inventory valuation
There are three commonly used types of inventory valuation; FIFO - First In, First Out, LIFO - Last In, First Out, and WAC - Weighted Average Cost.
FIFO: As the name implies, the company following the FIFO system will sell the goods purchased earlier first. So, the fresh stock will stay in inventory till the stock purchased earlier is exhausted. This reduces the risk of stock becoming dead stock by being too old to sell. The valuation would be done based on the price of each batch that was purchased.
LIFO: In the LIFO system, the last batch of an item bought is the very first to be sold. This means that the customer always gets the freshest goods. It, however, increases the risk of the existing stock in the warehouse getting left behind and becoming too old to sell. The valuation of the goods would be more detailed to account for the varying rates at which they were purchased.
WAC: The weighted average cost method counts the total number of purchased goods and calculates the average cost of the goods for the period.
What is the difference between FIFO and LIFO?
The difference between LIFO and FIFO in inventory valuation is that FIFO values the latest purchased stock while LIFO values the older stock. This means the value of the stock and the tax calculation for it works differently in an inflation market vs a deflationary market.
How do you calculate FIFO and LIFO?
The differences between the FIFO and LIFO methods are best understood with an example. Let us suppose a store has bought the same type of notebooks in batches every two months.
|
Purchase Month |
Quantity |
Rate |
Value |
|
January |
50 |
20 |
1000 |
|
March |
10 |
21 |
210 |
|
April |
50 |
23 |
1150 |
|
Total cost |
2360 |
||
|
Total No. purchased |
110 |
|
|
|
Total No. sold |
100 |
|
|
|
Total No. unsold |
10 |
|
|
Inventory valuation through the FIFO method
We see that the number of unsold notebooks is 10. In the FIFO method, the earlier batches of notebooks would have been sold and so it would be accurate to assume that the 10 unsold notebooks are from the latest batch. So they would be valued @ 23.
Inventory value= number of items x value = 10 x 23 = 230
Inventory calculation through the LIFO method
The LIFO method means that the 10 unsold books are from the oldest batch purchased. So, they would be valued @ 20.
Inventory value= number of items x value = 10 x 20 = 200
Inventory valuation through the WAC method
We would calculate as follows:
Total value of notebooks purchased = 2360
Total number of notebooks purchased= 110
Average value= Total value of notebooks purchased / Total number of notebooks purchased= 2360/110 = 21.45
Inventory value = average value x number unsold = 21.45 x 10 = 214.5
We can represent this information in a table as follows:
|
FIFO |
LIFO |
WAC |
|
The 10 unsold notebooks are presumed to be from the newest batch. So the earliest purchase price of 20 is used for the valuation. |
The 10 unsold notebooks are presumed to be from the oldest batch. So the latest purchase price of 23 is used for the valuation. |
The average value of the stock is calculated and used for valuation. |
|
|
|
Average value= Total value of notebooks purchased / Total number of notebooks purchased= 2360/110 = 21.45 |
|
Inventory value= number of items x value = 10 x 23 = 230 |
Inventory value= number of items x value = 10 x 20 = 200
|
Inventory value = average value x number unsold = 21.45 x 10 = 214.5
|
We can clearly see that the method used for calculator causes a lot of variation in the inventory valuation. When used over the entire inventory stock, the calculation method difference between LIFO and FIFO can make a huge difference to the inventory valuation on the company’s financial statements.
Which method is better, FIFO or LIFO?
To understand the difference between LIFO and FIFO, we need to compare them as follows
|
Comparison |
FIFO |
LIFO |
|
Method |
The items purchased first are sold first. |
The items purchased last are sold first. |
|
Market |
Calculated by the cost of goods unsold |
Calculated by COGS or cost of goods sold |
|
Stock |
Counts the number of the latest stock |
Counts the oldest stock |
|
Regulatory restrictions |
No restrictions |
IFRS does not recommend LIFO. GAAP allows it only within the US. |
|
Effects of inflation |
Shows a higher tax value |
Minimises the tax value |
|
Effects of deflation |
Lower tax value |
Higher tax value |
Is LIFO allowed under GAAP?
IFRS or International Financial Reporting Standards does not recommend LIFO. GAAP is the Generally Accepted Accounting Principles and it allows the use of LIFO in the USA. So, if you are a company operating in the US, you may use LIFO within the country but switch to the more commonly accepted FIFO for operations outside the US.
Which is the best inventory valuation method for your business?
As we see in the points above, there are many more points in favor of FIFO than LIFO. Additionally, FIFO is far more widely accepted than LIFO. So, unless there are specific reasons for using LIFO and it is allowed in your country, FIFO is a better choice.
