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For
many business owners, inventory valuation is a major issue that impacts
their P&L, balance sheet and taxes. The general rule of thumb is that
inventory should be valued at what you paid for it and the market value
(what it's worth). Unless the inventory is obsolete, your inventory is
generally valued at cost. But what is cost? Is it the last price you paid,
the first price or the average price? In addition, what does cost include?
Does cost include labor and overhead and freight or only the cost of the
purchases? Consider the following:
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What
is the effect of valuation inventory on the P&L? Your
P&L and balance sheets are interconnected. How you value inventory
determines costs of sales and therefore profit. The formula is as
follows:
Costs
of sales = (beginning inventory) + (inventory purchases) - (ending
inventory)
Ending
inventory depends on how you value inventory on your balance sheet.
Therefore, the lower the inventory, the higher the costs of sales, which
results in lower profit. Conversely, a higher inventory valuation results
in lower cost of sales and higher profits.
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What
are the different valuation methods? The
three main valuation methods are:
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First-in-first-out
(FIFO): This means your costs of sales is determined by the cost of
the items you purchased the earliest. Inventory is comprised of the
cost of the items you purchased the latest.
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Last-in-first-out
(LIFO): This means your costs of sales is determined by the cost of
the items you purchased the latest. It should be noted that depending
on your industry, LIFO is not allowed for tax purposes.
-
Weighted
average cost (WAC): Means that your costs of sales is determined by
the average cost of the items you purchased determined at the time of
sale.
In
the real world, you wouldn't have to do any manual calculations yourself
because your computer would do them for you. However, it's important to know
the differences. When costs are rising, FIFO would have the highest
inventory valuation and gross profit. When costs are falling, LIFO would
have the highest inventory valuation and gross profit. WAC estimates FIFO.
You
should also note that once you pick an inventory valuation method, you
generally have to stick with it. You cannot change every year without
raising eyebrows from your bankers and other readers of your financial
statements.
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What
is included in cost of inventory?
In addition to the cost of purchasing the inventory itself, costs of
inventory may include all costs that make the inventory available for
sale, such as duty, freight and, in the case of manufacturers, factory
labor and overhead. However, very few growing businesses include
anything but the actual cost of purchasing the inventory on their
financial statements. The reasons are twofold: First, including the
additional costs in inventory would decrease the cost of sales and
increase profit. Most small businesses want to minimize taxes and
therefore have an inventory value as reasonably low as possible. Second,
fully costing the inventory is time-consuming without the right software
program.
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