A Beginner’s Guide to Inventory Valuation Method
No matter what size, every business needs to have a robust inventory valuation method. An inventory valuation method allows you to gauge what your business is worth. It is the key that unlocks accurate data on your Cost of Goods Sold (COGS) and helps you measure your business’ profitability.
While inventory valuation technically falls under the bracket of accounting, it serves a great purpose in evaluating your business as a whole and determining your future outlook from both a financial and practical standpoint.
But navigating the complex terrain that is business accounting and valuation can be challenging and confusing, especially if you are a young or small business. That’s why we’ll take you through a straightforward guide to inventory valuation and its many different methods for success.
What Is an Inventory Valuation Method?
First, let’s focus on this term and what it means in the business world.
An inventory valuation method calculates the value of tangible materials or products kept in a business’ inventory at the end of a set accounting period.
That inventory includes any assets of value to the company that may be used in developing, producing, or distributing products/services. These include:
- Direct materials
- Direct labor
- Purchased goods
- Unsold stock
- Freight in
- Import duties
- Handling fees
- Factory overhead
So, essentially what inventory valuation covers are your current assets. Now, some of the assets listed above may not be relevant if you are a small business. However, regardless of scale, direct materials, labor, purchased goods, and unsold stock will all apply to your inventory valuation.
Plus, as your business continues to grow and expand over time, keeping track of these assets and forms of property will become increasingly important.
What Is the aim Of an Inventory Valuation Method?
The essence of inventory valuation methods can be split into two different objectives. With a strong method that works in alignment with the kind of business you run, an inventory valuation will:
- Determine your gross income
- Establish your financial position
Without a way to elucidate information like this, it will be challenging for your business to grow and expand at a healthy pace. Knowing your gross income and financial position allows you to make better business decisions moving forward.
The Four Different Inventory Valuation Method Types
There is no singular, standard type of inventory valuation that all companies use. In fact, three different methods can be used to reach the same (or similar) result. They are:
- First In First Out (FIFO) Method
The FIFO method is one used commonly amongst small businesses for its straightforward, uncomplicated approach. With FIFO, it is assumed that the oldest goods are sold first – i.e., the goods your business generates are sold in the same order in which they are produced.
Most companies already sell things in this order, thus maintaining a constantly-refreshed cycle of goods that make customers happy. With FIFO, the products or materials that are acquired by a business must be sold first.
- Last In First Out (LIFO) Method
The LIFO inventory valuation method is the exact opposite of the FIFO method. Instead of first selling the oldest products in the inventory, LIFO methods promote selling the most recently obtained products first. As the prices of goods increase, COGS numbers tend to be higher, making our overall taxable income lower.
- Weighted Average Cost (WAC) Method
The WAC inventory valuation method takes an entirely different approach to FIFO and LIFO. Instead of focusing on the age of products and materials, WAC calculates its COGS number by finding the average cost of all goods purchased within a stipulated amount of time.
This method works well for businesses with slight inventory variation, such as laptop manufacturers or small-scale furniture businesses. It’s typically not allowed by the IRS, however.
- Specific Identification Method
This method is used in businesses that trade in goods that are each 100% unique, such as an art gallery or boutique fashion label. If every item is unique in price, they will all need to be evaluated individually, which is where this inventory valuation method comes in.
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Why Inventory Valuation Is Crucial for Small Businesses?
Realistically, inventory valuation is necessary for any business, no matter the size. However, small businesses often need the structure, support, and foresight they can get to establish their name in their industry and continue to mature and develop rather than get lost in the fray.
With an effective inventory valuation system, any small business can start to learn more about itself and make better financial decisions regarding its future – amongst many other things. More benefits include:
- Avoid cash flow issues
When you have a more accurate understanding of stock, the risk of wastage is much lower. Without an inventory valuation, you may unknowingly buy more than you need, leading to stunted cash flow. You can order materials based on comprehensive financial data trends with a better system.
- Get bulk discounts
When you have a better understanding of what your stock needs are, you can make more intelligent, more cost-effective decisions regarding purchasing goods and materials. Instead of buying things as you need them, you can place bulk orders based on sales patterns that save you money.
- Maximize sales opportunities
With an inventory valuation system, you’ll never run out of supplies when you need them. You can know in advance when you are running low on essential materials and ensure no customer has to be turned away due to lack of preparation.
- Reduced storage costs
Sometimes, businesses miscalculate their inventory, leading to stagnant storage spaces. When you know exactly what’s coming and going and at what pace, you can significantly reduce your storage costs and ensure no wasted space is accumulated.
- Optimize profit margins
The more accurate and organized your inventory valuation system is, the easier it will be to see where your actual profit margins lie and how you can improve them. Closely tracked costs provide crucial clarity and insight into the operation of your business.
How To Pick an Inventory Valuation Method for Your Business?
Now that you understand the importance of using an inventory valuation system let’s take a look at how to pick one that aligns with your business strategy, style, and goals.
- FIFO – FIFO method typically results in a much larger inventory valuation than others. This is ideal if you are a company looking to attract big investors in the future.
- LIFO – during periods of high inflation, LIFO can be helpful. Because it puts more value on newer stock, it results in a much lower tax bill.
- WAC – if your business works with goods that are consistently identical, a WAC method will work well for you. It simplifies the inventory tracking process.
- Specific Identification – this method is designed for small-batch couture or one-of-a-kind goods, such as fine art or bespoke jewelry that appreciates over time.
Picking an inventory valuation method that speaks to your business’s industry and future goals is critical to its success. Speak to a financial advisor for more direct input, and remember that you can switch methods whenever you like – just aim to stick with the right one when you find it.
Inventory tracking is one of the most important key components of running any business. With a suitable method in place, you can make more informed financial decisions and widen your profit margin for a more cohesive, efficient, and growth-oriented business.
From FIFO to WAC, there is a wide range of different inventory valuation methods that you can choose from. Hopefully, this article helps shed some light on the importance of this financial practice and allows your business to flourish in a way that works for you.