[Updated post from May 19, 2022]
First in, first out, weighted average cost, financial statements…let’s face it; Inventory valuation is not the most riveting part of being an e-commerce business.
But e-commerce companies would be nothing without the inventory they sell, and in turn, nothing without inventory accounting.
Knowing and properly assigning value to your inventory directly affects your business’s financials – especially if you’re a fast-moving, high-SKU, direct-to-consumer brand. Let’s dive into everything you need to know about inventory valuation.
Inventory valuation refers to the process of assigning a monetary value to all of the inventory that a business holds. Valuing inventory correctly is a crucial aspect of accounting and financial reporting for businesses, especially at the end of an accounting period. How a business chooses to practice inventory valuation affects financial statements, balance sheets, tax calculations, and overall profitability assessment, making it an important – and challenging – aspect of inventory management.
The advantage of effective inventory valuation is that it helps businesses understand their finances and where capital is being tied up at a more granular level. It’s also an important factor in determining profits and whether they’re inflated or deflated during a particular timeframe.
So, why is inventory valuation important to running a successful business? To understand the value of inventory valuation, we need to take a quick step back to look at the importance of inventory itself.
For brands selling physical goods, inventory is quite literally the backbone of their business. Without inventory, there is nothing to make a profit from. In this context, inventory items can be understood as finished products that are being listed for sale as well as any raw materials or in progress products can will join listed stock at some point.
In sum, accurate inventory valuation ensures that businesses can make sound decisions that affect their financial performance and growth opportunities, such as:
Inventory is usually a business’s highest-value asset, and it can cost you significantly if you have more inventory on hand than you’re able to sell. How much inventory you have determines how much capital is tied up in unsold inventory stock, and in turn how this affects your decision-making. If your demand forecasting is off-base and you’re unable to match inventory levels with the amount of goods sold, remaining inventory accumulates and increases storage costs, as well as leading to poor customer experiences due to stockouts or canceled orders.
Selecting an effective inventory valuation method (and sticking to it) allows companies to better understand their products and how their value diminishes over time – which is an extremely helpful tool when the foundation of your business is a cycle of creating, receiving, and selling products. This assists the brand in selecting inventory that is more likely to hold its value and offer bigger profit margins.
Investing time and resources into proper inventory valuation helps businesses to understand their financial position, providing an in-depth measurement of profitability. This means future growth decisions like acquisitions or share-selling will be informed with only the most accurate picture of your profits, which helps to avoid poor decisions surrounding areas like pricing, sales tactics, inventory selection, and more.
Moreover, using the correct inventory valuation technique for your goods ensures that the profits reported to the tax authorities accurately reflect the company’s financial performance. Incorrect inventory valuation could lead to misleading profitability figures, which means staying on top of your inventory value allows you to stay compliant with the IRS.
However, there is a certain amount of wiggle room available to businesses. Different inventory valuation methods will produce different reported profits, which in turn affects the amount of income tax that a company owes. Businesses always need to follow the rules within their tax domicile to ensure they are
Being able to showcase a strong profit margin to stakeholders and potential investors is the key to accessing funding or loans that businesses need to continue growing and accessing new markets.
Both traditional banks and VC firms rely heavily on inventory value as a measure of creditworthiness and company stability. So, the inventory valuation method you choose during different financial periods plays a key role in presenting inventory value in the most positive light. For example, using the FIFO method during periods of inflation presents a higher gross profit.
Not only is there more than one inventory valuation method available for businesses to choose from when calculating inventory. There’s also a variety of factors that contribute to the end calculation. A business owner looking to properly value their inventory will need to take into account all costs that come when receiving, retaining, and preparing goods for sale. This is known as the Cost of Goods Sold (COGS).
COGS is calculated by taking their beginning inventory plus the items you buy over the year minus your ending inventory. Your Cost of Goods Sold directly determines your profits by subtracting COGS from your total revenue from sales.
The FIFO method is the inventory valuation method that most closely resembles the actual movement and cost of inventory. FIFO assumes that the oldest items within your inventory are sold first, either due to trend-based merchandise or product integrity requirements. For example, if you are a health and beauty brand, any items purchased in May should be sold before items purchased in June due to expiry dates. This means that when using FIFO, Cost of Goods Sold should be calculated using the oldest products in your inventory first.
Because FIFO follows real-life inventory movements very closely, this makes it a straightforward valuation method to apply. Because the cost of acquiring inventory usually rises over time, the FIFO method also typically generates the highest gross profits. If you’re always selling inventory purchased first, your cost of goods sold will be lower simply because the ending inventory is more expensive.
Because COGS will be lower overall when subtracted from your sales revenue, your profits are bound to be higher, which means you’ll likely pay more in taxes for the year. Plus, the FIFO method doesn’t always accurately depict your inventory spending if there’s a spike in prices. For businesses with complex inventory management systems, tracking how the costs of individual inventory items have fluctuated over time can be very challenging.
The LIFO method closely resembles the workings of a store shelf, where products at the front of the shelf are being bought and replaced while those at the back remain untouched. Essentially, LIFO assumes that the last items that enter your inventory last should be the first to be sold. This means your COGS is calculated using the costs of the most recently acquired inventory items first.
The LIFO method comes with notable tax advantages for retailers. When you’re pulling from your most recently acquired inventory, your cost of goods sold will be higher than if you were using a FIFO method, resulting in lower taxable profits. This makes LIFO particularly useful when prices are increasing, as COGS will reflect the most current market prices.
The LIFO method isn’t an intuitive way to manage your inventory and doesn’t reflect how the majority of businesses turn over inventory. Always selling the newest items first means that older items can lose value over time and end up sitting in a warehouse as dead stock.
For this reason, the LIFO method is not accepted for accounting purposes in all countries. It can be used in the US and is permitted both by the Internal Revenue Service (IRS) and Generally Accepted Accounting Principles (GAAP). However, LIFO is banned under the International Financial Reporting Standards (IFRS) and there are many places where it isn’t permitted due to how it can be used to distort profits.
The weighted average cost method takes an entirely different approach than FIFO and LIFO. Instead of focusing on new or old inventory value, WAC averages all inventory costs over the year by dividing the total cost of goods by the total number of units. Because WAC evenly distributes the cost of goods across all inventory items, it provides a more balanced representation of how inventory costs change over time.
The WAC method of inventory valuation requires fewer resources in terms of inventory tracking and management due to its simple approach, which can work well for smaller businesses that struggle to accurately track inventory costs. Weighted Average Cost also levels out fluctuations in inventory cost that happen over the year due to inflation or supply constraints.
While WAC does help to control fluctuations, this doesn’t always make it a good representation of actual inventory movements. Leveling price fluctuations may be a positive in some cases, but if there are large spikes in costs during the accounting period, businesses using the WAC method are more likely to have an inaccurate representation on their end-of-year balance sheet.
Taking the opposite approach to the weighted average cost method, the specific identification method tracks the individual cost of every item within your inventory to calculate COGS. This ensures that businesses have an accurate representation of inventory costs.
Specific ID is far by the most granular of all the inventory valuation methods. Because it gives each item a unique identifier, it provides the most accurate record of real inventory cost and profit. Therefore, your company can get a good sense of each item’s profitability in real time. This makes it appropriate for businesses that are selling one-of-a-kind inventory such as antiques or customizable items.
Tracking every single item in your inventory is extremely time-consuming, especially for businesses that sell products with hundreds of SKU variants, like clothing, footwear, or cosmetics. If products are trend-based and sell extremely fast, they may not be able to put the appropriate time and energy into inventory management. It also requires specific labeling of units by using methods such as the serial numbers of RFID tags, which are expensive to implement.
Choosing a valuation method that matches up with how your inventory moves in and out of your warehouse makes it much easier to calculate COGS and apply the most suitable calculation. Key factors to consider are the type of inventory you’re selling, how much inventory you’re carrying, and how much the purchase price of inventory changes throughout the year.
Future business activities hold huge sway over which inventory valuation method still serves your needs best. If you’re hoping to access more favorable loan conditions, for example, the FIO method helps you present a more profitable balance sheet to potential investors. Alternatively, WAC may be a good choice if your business is focused on getting a highly accurate overview of inventory costs.
Accounting regulations in different states or countries may have different rules concerning which inventory valuation methods you are allowed to use. LIFO is permitted in the U.S., for example, but not in many other territories. It’s the responsibility of the business to make sure they are using a permissible valuation method and reporting on their inventory correctly.
Different inventory valuation methods require different levels of detail when it comes to inventory management. It isn’t possible to use the specific identification method, for example, if you don’t know the actual cost of every item in your inventory. If you lack high-powered inventory management software, your business might not have this information to hand, making a method like FIFO or WAC more appropriate for your needs.
Your business needs to present strong financials. Whether you need to qualify your business for bank loans, or present the highest inventory value possible to attract investors or partners, the FIFO method typically produces the highest gross income.
Your business is dealing with high inflation. Because LIFO focuses on older and cheaper inventory, your new inventory with the highest prices won’t have as much of an effect on your tax bill.
You have a large number of items that are identical (or very similar). With the weighted average cost method, your inventory valuation process will be less stressful. However, it’s important to note that this is simpler at the cost of a less accurate gross profit.
There’s one of a one-of-a-kind items in your product catalog. This means your inventory consists of specialized products that require value authentication from the business, investors, and customers alike. For example, those buying and selling high-value, vintage cars will want to know the current price and the historical price.
Whether you decide to go with a weighted average cost method or a FIFO method, Ryder E-commerce’s proprietary e-commerce platform makes tracking and valuing inventory all the more straightforward. Our technology allows you to identify, track, and manage all of your products and SKU variations in real-time so you won’t miss a beat when it comes to understanding your company’s inventory – what’s selling, what’s not, and what is most valuable. Get in touch today to find out how Ryder E-commerce can assist your brand with seamless inventory management.