Comparing Inventory Valuation Methods

Inventory valuation is an important part of the accounting function in any manufacturing or merchandising business. Inventory is a vital factor that affects the company’s cash flow, balance sheet and income statement, and there is a good chance that a big part of your capital is tied to or invested in your inventory. Moreover, investors are also concerned about the correct valuation of inventory items because it can definitely affect the market price of the company’s stocks. You should compare a few generally accepted methods of valuing inventories to consider what would best suit your business.

3 Common Methods

The first-in, first-out (FIFO) method is based on the assumption that the first item or unit that is entered in the inventory will also be the first one to be sold, consumed or used.

Meanwhile, the last-in, first-out (LIFO) method is founded on the thinking that the last unit to be included in the inventory will be the first one to be sold, consumed or used.

Finally, there’s the average cost method, which appraises inventory simply by taking the weighted average cost of all the items or units in the inventory. Here, the number of items sold and the inventory on hand will be multiplied by the average cost to arrive at the total cost of goods sold and the ending inventory, respectively.

Effects on the Valuation of the Ending Inventory

When the FIFO method is used, the value of the ending inventory will match the latest or most recent production costs or purchase price of the units in the inventory. For most experts, this provides a better indication of how much inventory is on hand. The LIFO method, however, will result in an ending inventory valuation based on the unit cost of the older inventory items or batches. With that in mind, LIFO may not reflect the true or approximate value of the ending inventory. As with the average cost method, the value of the ending inventory will fall somewhere in the middle of the FIFO and LIFO valuations.

Inventory Valuation and Rising Prices

When the prices of goods are rising, using FIFO will give you a bigger inventory value on your balance sheet. You will also have bigger tax liabilities. However, a bigger inventory on your financial statements can help improve your credit standing, which is important if you need to apply for loans to grow your business.

Meanwhile, LIFO will tend to decrease inventory value and your depreciation allowance. This method is ideal if you want to have lower taxes, but it is not suitable if you want to apply for loans and additional funding because it can bring down earnings per share and your credit score. As with the average cost method, the effects of rising prices will be minimal because you tend to take the average between the oldest and the most recent production costs or purchase prices.

Inventory Valuation and Falling Prices

If you are using FIFO when prices are plummeting, your inventory will have a lower valuation on the balance sheet, as the value will be based on the most recent prices. LIFO will cause your income to rise if the market prices are falling, and the average cost method will have a middle-of-the-road valuation between FIFO and LIFO.

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