How to Value Inventory for Your Business’s Financials

Inventory valuation is the process of assigning a monetary value to goods a business holds for sale. This practice is fundamental for accurate financial reporting, directly impacting a company’s financial statements. It helps determine the value of products available for sale and those sold, reflecting a company’s financial health.

Understanding Inventory Valuation Methods

Inventory valuation methods dictate how the cost of goods sold (COGS) and the value of remaining inventory are calculated. Businesses commonly use three primary methods: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost. Each method makes a different assumption about inventory flow, influencing reported financial figures.

First-In, First-Out (FIFO)

The FIFO method assumes that the first inventory items purchased are the first ones sold. This means the costs of the oldest inventory are assigned to the Cost of Goods Sold, while the most recent purchases remain in ending inventory. This method often aligns with the physical flow of goods, especially for perishable items.

For example, if a business buys 100 units at $10, then 100 units at $12, and sells 150 units, FIFO assigns the first 100 units sold a cost of $10 each, and the next 50 units a cost of $12 each. The Cost of Goods Sold would be (100 $10) + (50 $12) = $1,600. The ending inventory would be the remaining 50 units at $12 each, totaling $600.

In periods of rising prices, FIFO generally results in a lower Cost of Goods Sold and a higher ending inventory value, leading to higher reported net income. This method is widely accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Last-In, First-Out (LIFO)

The LIFO method assumes that the last inventory items purchased are the first ones sold. This means the most recent purchase costs are assigned to the Cost of Goods Sold, and older costs remain in ending inventory. While this may not reflect the physical flow of goods, it can be advantageous for tax purposes.

Using the same example, if 150 units are sold, LIFO assigns the last 100 units purchased a cost of $12 each, and the next 50 units a cost of $10 each. The Cost of Goods Sold would be (100 $12) + (50 $10) = $1,700. The ending inventory would be the remaining 50 units at $10 each, totaling $500.

In an inflationary environment, LIFO results in a higher Cost of Goods Sold and a lower ending inventory value, leading to lower reported net income and potentially lower tax liabilities. LIFO is permitted under U.S. GAAP but is prohibited under IFRS.

Weighted-Average Cost

The Weighted-Average Cost method calculates an average cost for all inventory items available for sale during a period. This average cost is applied to both the Cost of Goods Sold and the ending inventory. This method smooths out price fluctuations, as it does not rely on specific assumptions about the order of sales.

To calculate the weighted-average cost, divide the total cost of goods available for sale by the total number of units. For instance, if a business has 100 units at $10 and 100 units at $12, the total cost is $2,200 for 200 units. The weighted-average cost per unit is $2,200 / 200 = $11.

If 150 units are sold, the Cost of Goods Sold would be 150 units $11 = $1,650. The ending inventory would be the remaining 50 units $11 = $550. This method is acceptable under both U.S. GAAP and IFRS.

Inventory Management Systems

Businesses utilize inventory management systems to track the movement of goods, affecting how inventory valuation methods are applied. The two main systems are the Periodic inventory system and the Perpetual inventory system. Each system has distinct characteristics regarding when and how inventory levels and costs are updated.

Periodic System

Under the Periodic inventory system, businesses do not continuously track inventory levels. A physical count of inventory is performed at specific intervals, typically at the end of an accounting period. This count determines the quantity of ending inventory on hand.

The Cost of Goods Sold is calculated using the formula: Beginning Inventory + Purchases – Ending Inventory. For example, if a business started with $5,000 in inventory, made $10,000 in purchases, and counted $4,000 in ending inventory, the Cost of Goods Sold would be $5,000 + $10,000 – $4,000 = $11,000.

Perpetual System

The Perpetual inventory system maintains continuous, real-time records of inventory balances. Every purchase and sale of inventory is immediately recorded, updating both the quantity and cost of inventory on hand. This allows businesses to know the exact quantity and cost of inventory at any given moment.

When a sale occurs, the Cost of Goods Sold is immediately updated, and the inventory account is reduced. This real-time tracking facilitates better inventory control and management, as businesses can monitor stock levels, identify discrepancies, and make purchasing decisions more efficiently. While more technologically demanding, it provides more granular data for decision-making.

The choice of inventory system influences the timing of valuation method calculations. With a Periodic system, FIFO, LIFO, and Weighted-Average calculations are typically performed at the end of the period based on a physical count. With a Perpetual system, these calculations are applied continuously as purchases and sales occur, providing updated figures after each transaction.

Lower of Cost or Market Principle

The Lower of Cost or Market (LCM) principle is an accounting guideline under U.S. GAAP that ensures inventory is not overstated on a company’s balance sheet. This principle dictates that inventory must be reported at the lower of its historical cost or its current market value. This conservative approach prevents overstating assets and profits when inventory value declines.

Market value generally refers to the replacement cost of the inventory. However, it cannot exceed the net realizable value (estimated selling price minus costs to complete and sell) and cannot be lower than the net realizable value less a normal profit margin. If replacement cost falls outside these bounds, the net realizable value or the net realizable value less a normal profit margin is used as the market value.

For example, if a product was purchased for $100 (historical cost) but its current replacement cost is $80, with a net realizable value of $95 and net realizable value less a normal profit margin of $75. The market value would be $80, as it falls between $95 and $75. Since the market value ($80) is lower than the historical cost ($100), the inventory would be written down to $80.

This write-down results in a loss, recognized as an expense in the Cost of Goods Sold on the income statement. If the loss is substantial, some businesses may report it in a separate account, such as “Loss on LCM adjustment,” to highlight its impact. This principle provides a transparent depiction of a company’s financial health by reflecting any impairment in inventory value.

Under IFRS, a similar principle called “Lower of Cost and Net Realizable Value” (LCNRV) is applied. LCNRV specifically uses net realizable value as the market comparison, defined as the estimated selling price less estimated costs of completion and sale. Unlike U.S. GAAP, IFRS permits the reversal of inventory write-downs if the net realizable value subsequently increases.

Considerations for Choosing a Method

Selecting an inventory valuation method impacts a business’s financial statements and can influence how stakeholders perceive its performance. The chosen method directly affects reported figures such as gross profit, net income, and asset value on the balance sheet. For instance, in an inflationary environment, FIFO typically yields higher reported net income compared to LIFO.

Consistency is a foundational accounting principle for inventory valuation methods. Once a business selects a method, it should apply it consistently from one accounting period to the next. This ensures financial statements are comparable over time, allowing for meaningful analysis. Any change in method requires specific disclosure in the financial statements.

Tax implications are a significant factor in method selection, especially in the United States. The LIFO method can result in a higher Cost of Goods Sold and lower taxable income during periods of rising prices, potentially deferring tax payments. Internal Revenue Code Section 472 includes the “LIFO conformity rule,” which mandates that if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting. This rule prevents businesses from reporting higher profits to investors while reporting lower profits to the IRS for tax benefits.

Industry practices also guide the choice of method. Businesses dealing with perishable goods, like food, often find that FIFO naturally reflects their inventory’s physical flow. Industries where the most recent costs are more relevant to current revenues, such as those with frequently changing product designs, might consider other methods.