First in, first out, weighted average cost, financial statements… inventory valuation is not the most riveting part of being an e-commerce business.
Let’s face it; 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 is the process of understanding and assigning a clear value to your inventory, especially at the end of an accounting period where financial statements (like a company’s balance sheet) are required. Sounds easy, right? Well, not exactly.
Not only is there more than one inventory valuation method to choose from; but there’s also an abundance of factors that attribute to the end calculation. A business owner looking to properly value their inventory will need to take into account any and all costs that come when receiving, retaining, and preparing goods for sale.
Not to fret; inventory valuation will only get easier as you go along, all while helping you to understand your business at a more granular level. Plus, it’s an important factor in determining your profits and whether they’re inflated or deflated during a particular timeframe.
In order to understand the value of inventory valuation, we’ll need to take a quick step back to look at the importance of inventory itself.
Inventory is an essential part of running a successful online business. It’s usually your highest value asset, and it can cost you significantly if you have more inventory on-hand than you’re able to sell (hello, excess inventory). Plus, it directly affects your customers. If your demand forecasting was off and you’re unable to match inventory to the amount of goods sold, it leads the way for a less-than-satisfying customer experience.
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 to have when the foundation of your business lies within a cycle of creating, receiving, and selling product.
Plus, staying on top of your inventory value allows you to stay compliant with the IRS and creates a smaller margin of error when it comes to providing numbers for taxes. Let’s break it down:
Above all, investing the time and resources into proper inventory valuation will help you understand your company’s financial position, providing an in-depth measurement of your profitability. This means future growth decisions like acquisitions or share-selling will be informed with only the most accurate picture of your profits.
The FIFO method is the inventory valuation method that most closely resembles the actual movement and cost of inventory. How? FIFO assumes that your oldest inventory is sold first. For example, if you have a health and beauty ecommerce brand, any items purchased in May will be sold before items purchased in June.
Pros: Because the cost of acquiring inventory usually rises over time, the FIFO method 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.
Cons: With an overall lower cost of goods to subtract from your sales revenue, your profits are bound to be higher, which means you’ll 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.
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, any items that enter your inventory last should be the first to be sold.
Pros: The LIFO method comes with notable tax advantages for retailers. Why? 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 profits to be taxed on.
Cons: The LIFO method is not exactly an intuitive way to manage your inventory. Always selling your newest items first means that your older items completely lose value over time and end up just sitting in the warehouse as dead stock.
Another factor to take into account is where the LIFO method is accepted. While it can be used in the US, and is permitted 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 countries where it isn’t permitted.
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.
Pros: The WAC method of inventory valuation requires fewer resources dedicated to inventory tracking and management due to its simpler approach, which can work well for businesses who aren’t able to properly track inventory costs. Plus, because of the averaging nature of WAC, it levels fluctuations in inventory cost over the course of the year.
Cons: While leveling price fluctuations may be a positive for some, if there are large spikes 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 on the opposite approach of WAC, the specific identification method tracks each specific item in your inventory as well as the cost. The thing is, it requires specific labeling of units by using the serial numbers of RFID tags. This means it’s more likely to be used for businesses housing one-of-a-kind inventory like antique, high-value items.
Pros: Specific ID is the most accurate of all the inventory valuation methods. Because it takes each item into account with a unique identifier, it provides the most accurate record of real inventory cost and profit. Therefore, your company is able to get the best sense of each item’s profitability in real-time.
Cons: Tracking every single item in your inventory is tedious. Businesses that have thousands of same-SKU products, like make-up brands with a hot-item lip gloss, may not be able to put the appropriate time and energy into inventory management.
Choosing the right inventory valuation method is a huge decision for brands. It really depends on the specific product you’re selling, how the price fluctuates, as well as business goals like whether you’re applying for loans or trying to attract investors.
Whether you decide to go with a weighted average cost method or a FIFO method, Ryder Ecommerce by Whiplash’s proprietary ecommerce platform makes valuing inventory all the more straightforward.
The Whiplash technology allows you to track and manage your products in real-time, so you won’t miss a beat when it comes to having a strong grasp on your company’s inventory – what’s selling, what’s not, and what’s most valuable. Get in touch today to find out how Ryder Ecommerce by Whiplash can assist your brand with inventory management and omnichannel fulfillment.