What Is Inventory Valuation? Methods & Financial Impact

Inventory valuation is a fundamental accounting process for businesses handling physical products. It assigns a monetary value to goods held for sale, including raw materials, work-in-process, or finished goods. This valuation directly impacts a company’s financial statements by determining the cost of goods sold and the value of inventory reported as an asset. Accurate valuation is necessary for financial reporting, tax compliance, and informed business decision-making.

Understanding Inventory Cost

Inventory cost includes all expenditures to bring goods to their current condition and location, ready for sale or production. This encompasses direct costs like the purchase price from suppliers, freight-in charges, import duties, taxes, and insurance during transit. Processing or handling fees directly attributable to preparing inventory are also included. These are inventoriable costs, recorded as an asset until the inventory is sold.

Period costs are expenses not directly tied to inventory acquisition or production. Examples include administrative salaries, marketing expenses, and general overhead. These costs are expensed when incurred, rather than being added to inventory value. Distinguishing between inventoriable and period costs is important for accurate financial reporting.

Primary Inventory Valuation Methods

Businesses use different methods to assign costs to inventory, even if the physical flow of goods remains the same. These cost flow assumptions determine which costs are considered sold and which remain in ending inventory. The three primary methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the Weighted-Average Method.

FIFO (First-In, First-Out)

The FIFO method assumes the first goods purchased or produced are the first ones sold. This means the oldest inventory costs are expensed as Cost of Goods Sold (COGS), while the most recently acquired costs remain in ending inventory. This method typically aligns with the physical flow of perishable items or those with limited shelf lives.

For example, if a company bought 100 units at $10 and 150 units at $12, and then sold 200 units: under FIFO, the first 100 units are costed at $10, and the next 100 units at $12. This results in a COGS of $1,000 (100 $10) plus $1,200 (100 $12), totaling $2,200. The remaining 50 units in ending inventory are valued at $12 each, totaling $600.

LIFO (Last-In, First-Out)

The LIFO method assumes the last goods purchased or produced are the first ones sold. The most recent costs are expensed as COGS, and the oldest costs are assigned to ending inventory. This method is often chosen in periods of rising prices because it typically results in a higher COGS and lower taxable income.

Using the same example, if 200 units are sold: under LIFO, the most recent 150 units are costed at $12, and the remaining 50 units from the first purchase at $10. This leads to a COGS of $1,800 (150 $12) plus $500 (50 $10), totaling $2,300. The ending inventory of 50 units is valued at $10 each, totaling $500. LIFO is generally not permitted under International Financial Reporting Standards (IFRS), but it is allowed under U.S. Generally Accepted Accounting Principles (GAAP).

Weighted-Average Method

The weighted-average method calculates an average cost for all goods available for sale during a period. This average cost is applied to both units sold (COGS) and units remaining in ending inventory. This method smooths out price fluctuations, providing a more consistent cost assignment than FIFO or LIFO.

Continuing the example, the total cost of goods available for sale is $1,000 (100 units at $10) plus $1,800 (150 units at $12), equaling $2,800. Total units available are 250 (100 + 150). The weighted-average cost per unit is $2,800 divided by 250 units, which is $11.20. COGS for 200 units sold is $2,240 (200 $11.20), and ending inventory for the remaining 50 units is $560 (50 $11.20).

Impact on Financial Statements

The choice of inventory valuation method directly influences a company’s financial statements, particularly the income statement and balance sheet. This impact is especially pronounced during periods of inflation or deflation.

In an inflationary environment, FIFO typically results in a lower COGS, assuming older, cheaper inventory is sold first. This leads to higher reported gross profit and net income. Conversely, LIFO results in a higher COGS during inflation, matching recent, higher costs against revenues, leading to lower gross profit and net income. The weighted-average method generally falls between FIFO and LIFO in its impact on profitability during inflationary periods.

For the balance sheet, FIFO leaves recent, higher costs in ending inventory during inflation, resulting in a higher reported inventory asset value. LIFO leaves older, lower costs in ending inventory, leading to a lower reported inventory asset value. The weighted-average method provides a middle ground for inventory asset valuation.

The choice of method also carries tax implications for U.S. companies. Under the LIFO conformity rule, if a business uses LIFO for tax purposes to reduce its taxable income, it must also use LIFO for its financial reporting to shareholders and creditors. This rule, Internal Revenue Code Section 472, prevents companies from reporting higher profits to investors while simultaneously reporting lower profits to the Internal Revenue Service for tax benefits.

Other Important Valuation Principles

Beyond cost flow assumptions, other principles guide inventory valuation to ensure financial statements provide a reliable picture of a company’s assets and earnings. These principles help maintain consistency and conservatism in reporting.

The Lower of Cost or Market (LCM) rule requires inventory to be reported at the lower of its historical cost or current market value. This rule prevents overstating inventory value on the balance sheet if the market price declines due to obsolescence, damage, or falling demand. If the market price is lower than cost, the inventory must be written down, and the loss recognized in the current period, adhering to conservatism.

The consistency principle dictates that once an inventory valuation method is chosen, it should be applied consistently from one accounting period to the next. This ensures comparability of financial statements over time, allowing users to analyze trends and performance without distortions caused by method changes. While a change in method is permissible under specific circumstances, it typically requires justification and disclosure in financial statements.

For businesses dealing with unique, high-value items, such as custom-made jewelry, rare art, or specific real estate developments, the specific identification method may be used. This method tracks the actual cost of each individual item, directly assigning that cost to COGS when sold and to ending inventory if unsold. Unlike FIFO, LIFO, or weighted-average, specific identification does not rely on cost flow assumptions but on the direct traceability of individual unit costs.