How to Calculate the Value of Inventory

Inventory valuation assigns a monetary value to goods a business holds for sale at the end of an accounting period. This fundamental process directly influences financial statements and reported profitability. Accurate valuation ensures a true picture of financial health, impacting cost of goods sold, net income, and tax obligations.

Components of Inventory Cost

The cost of inventory includes all expenditures to bring goods to their current location and condition. This encompasses the purchase price, after trade discounts or rebates. Direct costs like freight-in, import duties, and other acquisition taxes are also included. For manufactured goods, inventory cost further incorporates direct labor and production overhead, such as indirect materials, indirect labor, and factory utilities, necessary for converting raw materials into finished products.

Certain costs are excluded from inventory value and recognized as expenses when incurred. These include abnormal amounts of wasted materials, labor, or other production costs. Storage costs are generally expensed, unless necessary for production before a subsequent stage. Selling costs, like sales personnel salaries and advertising, are also excluded. General administrative overheads not contributing to bringing inventory to its present location and condition are expensed.

Primary Cost Flow Assumptions

Businesses use various cost flow assumptions to determine inventory value and cost of goods sold, which may not always align with the physical flow of goods. The three primary methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost. These methods consistently assign costs to inventory items.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first sold. Oldest costs are assigned to Cost of Goods Sold (COGS), while ending inventory reflects the most recently acquired items. FIFO is permitted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). This method often aligns with the physical flow of perishable goods.

Let’s illustrate with an example. Assume a company has the following inventory activity in January:
Beginning Inventory: 0 units
Purchases:
January 5: 100 units @ $10 = $1,000
January 15: 150 units @ $12 = $1,800
January 25: 200 units @ $13 = $2,600
Sales:
January 20: 200 units
January 30: 100 units

Under FIFO, the 300 units sold are assumed to come from the earliest purchases. This means 100 units from January 5 ($10/unit), 150 units from January 15 ($12/unit), and 50 units from January 25 ($13/unit) are sold. Therefore, the Cost of Goods Sold (COGS) is $1,000 + $1,800 + $650 = $3,450.

Total units available for sale are 450 (100 + 150 + 200). With 300 units sold, 150 units remain in ending inventory. Since FIFO assumes oldest units are sold first, ending inventory consists of the most recent purchases. The 150 units in ending inventory are from the January 25 purchase, costing $13 per unit (150 units $13 = $1,950).

Last-In, First-Out (LIFO)

The Last-In, First-Out (LIFO) method assumes the most recently purchased goods are the first sold. Latest costs are assigned to Cost of Goods Sold, while ending inventory reflects the earliest acquired items. LIFO is permitted under U.S. GAAP but prohibited under IFRS. U.S. companies may use LIFO to minimize taxable income during periods of rising costs.

Using the same example data:
Beginning Inventory: 0 units
Purchases:
January 5: 100 units @ $10 = $1,000
January 15: 150 units @ $12 = $1,800
January 25: 200 units @ $13 = $2,600
Sales:
January 20: 200 units
January 30: 100 units

Under LIFO, the 300 units sold are assumed to come from the latest purchases. This means 200 units from January 25 ($13/unit) and 100 units from January 15 ($12/unit) are sold. Therefore, the Cost of Goods Sold (COGS) is $2,600 + $1,200 = $3,800.

With 150 units remaining, and LIFO assuming newest units are sold first, ending inventory consists of the oldest remaining purchases. The 150 units in ending inventory would be 100 units from the January 5 purchase ($10/unit = $1,000) and 50 units from the January 15 purchase ($12/unit = $600), totaling $1,600.

Weighted-Average Cost

The Weighted-Average Cost method calculates an average cost per unit for all goods available for sale. This average cost is applied to both units sold and units remaining in inventory. Permitted under both U.S. GAAP and IFRS, it provides a smoothed-out cost basis, advantageous for businesses selling identical products in bulk.

Using the same example data:
Beginning Inventory: 0 units
Purchases:
January 5: 100 units @ $10 = $1,000
January 15: 150 units @ $12 = $1,800
January 25: 200 units @ $13 = $2,600
Sales:
January 20: 200 units
January 30: 100 units

First, calculate the total cost of goods available for sale ($1,000 + $1,800 + $2,600 = $5,400) and total units available (100 + 150 + 200 = 450 units). The weighted-average cost per unit is $5,400 / 450 units = $12.00. The Cost of Goods Sold (COGS) for 300 units sold is 300 units $12.00/unit = $3,600. Ending Inventory for the 150 remaining units is 150 units $12.00/unit = $1,800.

Adjusting Inventory Value

After applying a cost flow assumption, inventory value may need further adjustment under the “Lower of Cost or Market” (LCM) rule, or “Lower of Cost and Net Realizable Value” (LCNRV) under IFRS. This rule ensures inventory is not overstated on the balance sheet if its value declines due to damage, obsolescence, or falling market prices. U.S. GAAP uses LCM, where “market” refers to replacement cost. IFRS requires LCNRV, where Net Realizable Value (NRV) is the estimated selling price less any costs to complete and sell.

To apply this rule, the cost of each inventory item (determined by FIFO, LIFO, or weighted-average) is compared to its market or net realizable value. Inventory is then reported at the lower of the two figures. For example, if a product originally cost $50 but its net realizable value is now $40, it would be valued at $40. This write-down reduces inventory value on the balance sheet and increases Cost of Goods Sold on the income statement, reflecting the loss.

Understanding the Impact of Valuation Methods

The chosen inventory cost flow assumption directly influences a company’s financial statements. Cost of Goods Sold (COGS), ending inventory balance, gross profit, and net income are all affected. These impacts become more pronounced during periods of rising or falling costs.

In a rising cost environment, FIFO assigns older, lower costs to COGS, leading to lower COGS and higher gross profit and net income. This also results in a higher ending inventory value, reflecting more recent, higher costs. Conversely, LIFO assigns newer, higher costs to COGS in a rising cost environment, resulting in higher COGS and lower gross profit and net income. LIFO’s ending inventory value will be lower, representing older, lower costs. The weighted-average method generally produces COGS and ending inventory values that fall between FIFO and LIFO during periods of changing prices.

During a period of falling costs, the effects on financial statements are reversed. FIFO results in higher COGS and lower net income because older, higher costs are expensed first. LIFO leads to lower COGS and higher net income as newer, cheaper costs are expensed. The choice of method can also impact tax liabilities; for example, lower net income under LIFO during inflation can reduce taxable income. Understanding these differences is important for financial reporting and analysis.