Inventory Valuation Methods

Inventory generally refers to stock or stock in trade.

In trading, it refers to perpetual inventory meant for resale or unsold goods. In a manufacturing concern, it includes items such as raw materials, semi-finished goods, and finished goods.

An inventory valuation allows your company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and a correct measurement of them is necessary to assure that you get accurate financial statements. If you don’t properly measure your inventory, your expenses and revenues cannot be matched and you could make poor business decisions.

This is crucial as the excess or shortage of inventory will affect the production and profitability of your business.

Inventory valuation method evaluates inventories at the economic level. These techniques are of great importance when the prices for acquired units are different. Companies should be aware of the inventory cost. Otherwise, they cannot perform the calculations of the cost of the goods sold, nor the value of their existence when the exploitation cycle ends. Due to this, these methods are the perfect tool to know the importance of inventories. It can be done by monetary units and the price of goods that have already been sold over time.

Importance of Inventory Valuation in Companies

Because, it has a direct relationship with the control and excellent handling of products. Moreover, it allows them to provide the customer with better service and efficient production.

Consequently, the financial administrator of the company must find a way to solve any problem that occurs during the development of operations. This is due to the responsibility in production, the allocation of sales costs, and of the goods that are in the inventory. In the same way, it allows the determination of the economic situation of the company during the period specified and the user management of the operating system.

Within the importance of the inventory valuation, the following objectives are :

Detention of costs in inventory accounts until sale of products.
The proper final inventory value integrates into the state of the economic situation.
It is necessary to determine the total inventory cost of the purchased inventory.
The valuation corresponding to the amount of cost of sales must be correct when facing the income of the period. It has to be present in the state of the financial situations.

Inventory valuation stocks of supplies and merchandise for consideration should attend value at their inventory cost. The inventory cost is obtained by adding the cost price and all costs directly attributable to the acquisition (incidental purchase costs).

Methods Used For Inventory Valuation

Organizations make precise assumptions about sale of goods and remain in inventory units. Hence, resulting in variety of accounting methods. There are two most common methods that retailers use:

Weighted Average Cost (WAC)
First-In-First-Out (FIFO)

The Weighted Average unit Cost (WAC) method

The Weighted Average Unit Cost (WAC) method consists of calculating a weighted average cost by dividing the total current costs by the total of the quantities acquired.

This is an accounting technique for the valuation purposes of current inventory and has recognition under financial transactions. Companies make certain assumptions about sale of goods and which goods remain in inventory (resulting in different accounting methodologies).

The calculation of the weighted average unit cost can be made:

either on the occasion of each entry into stock (especially in the case of permanent inventories),
either at the end of each period (especially in the case of intermittent stockpiles). It often corresponds to the average duration of storage.

The weighted average cost method (WAC) is generally used for the valuation of non-perishable material stock that can be stored over a long period. In practice, the weighted average unit cost is calculated automatically by the inventory management application used by the company.

The weighted average unit cost at each entry into the stock- The company can update the weighted average unit cost of a product for each new in-stock. At each new entry, the net realizable value adjusts to reflect the latest entry of products at a fix price.

Calculation of weighted average cost with each entry into the stock

The weighted average unit cost calculated automatically for ending inventory is obtained as follows:

WAC = (Previous stock value at the old WAC + current cost of the ending inventory) / Total quantities in stock. The weighted average unit cost may also be calculated at the end of the period. The duration of the period frequently corresponding to the average storage period (stock turnover period) or a shorter duration.

By calculating the weighted average unit cost at the end of the period, we must first determine the duration of rotation of the stock. The calculation is as follows:

Stock Turnover Time = Quantities Released for Sales / Average Stock. If the company does not have a permanent inventory, the average stock is equal to the average between the initial stock and the final stock.

Once the rotation period is clear, we add all the inventory costs over the accounting period (we retain all the goods in stock). Then, we divide this amount by the total of the quantities entered in stock in the same period.

WAC = Total inventory cost of entries over the period / Total quantities entered during the period.

Example of application of Weighted Average Cost method(WAC) :

Suppose you added a total of 80 shirts to your inventory, of which you paid $10 per product for 40 of them and $15 per product for the rest. You would calculate the WAC as:

Cost of Goods Sold (per item)= {[Cost 1 X Quantity 1] + [Cost 2 X Quantity 2]} / Total quantity. In this example, Cost of Goods Sold (per item) = {[10 X 40] + [15 X 40]}/ 80 = $12.5 Irrespective of which order you sell the product in, for that time period, you will always account for the cost of inventory units as $12.5 per product.

The first-in, first-out (FIFO) method

In this method, you assume that the oldest inventory is also the first ones to be on sale. You always sell your oldest goods first. The obvious benefit of this method is that it accurately reflects how most retailers do business.

The first-in, first-out (FIFO) method consists of valuing inventories at the latest acquisition or production costs. This is one of the two overall valuation techniques having legislation recognition; the other technique being the weighted average unit cost (WAC) which is already mentioned above.

For this, value of each out of stock at the cost price of the oldest inventory.

Thus, during the inventory, the outcomes of the same category in stock are the most recent. With the most recent acquisition costs you can evaluate them.

The FIFO method is tax-only for interchangeable inventory items.

For the evaluation of the products in stock, one uses, in particular, the method Premium Exchangeable Participating Security (PEPS) with perishable products to take out the oldest articles in order to avoid that they lose value. The FIFO method has the disadvantage of delaying changes in the prices of supplies and remaining inventory.

Example of application of the First In First Out method (FIFO)

Here are the movements affecting a product category of a company during the year. Considering that it corresponds to the calendar year and that the company values its stocks according to the FIFO method, in :

January: purchase of 100 products at a unit purchase cost of 10 dollars,
March: sale of 50 products,
June: sale of 20 products,
July: purchase of 50 products at a unit purchase price of 11 dollars,
September: sale of 30 products,
November: sale of 30 products,
December: purchase of 50 products at a unit purchase price of 9 euros.

As of December 31, there are 70 products in this category in the company’s inventory. By applying the FIFO method, outflows value at the cost of the oldest product in stock.

Conclusion on inventory valuation methods

The Weighted Average Cost Method (WAC) and first-in, first-out (FIFO) are two primary methods for inventory valuation. However, it is hard to say if one way is better than the other.

If you are looking to identify the inventory value of your business – then Weighted Average Cost is the best and correct method to use. If you are looking to calculate the Cost of Goods Sold (COGS), then both FIFO and WAC have global acceptance.

FIFO actually gives a better estimate of your Gross Margins as compared to WAC as businesses generally sell their oldest items well It absolutely depends on the type of valuation and what is it that you are looking for through your valuation. Nevertheless, when it comes to inventory valuation methods, it is essential to know your requirements before choosing the right one for you.

Things become much easier if you use a good inventory management software . You can try ProfitBooks which helps businesses to manage entire inventory cycle from purchase to sales.

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