Basics of Inventory Valuation
For merchandisers, manufacturers and wholesalers, inventory is often times the largest asset item represented on the balance sheet as a current asset. It is considered one of the more liquid assets because the basic assumption is that inventory owned by a company will be sold in the near future and converted to cash (the most liquid of any asset type). Inventory includes items that are ready for sale (finished goods), items in the process of being produced (work in progress) and raw materials that will be used to produce the final goods.
The way inventory is valued therefore becomes a crucial evaluation point for external parties comparing financial statements of similar companies. In addition to impacting the balance sheet, inventory management and the valuation method chosen by a company can directly affect profitability measures like gross margin on the income statement. Moreover, there is an impact to cash flow since profitability has a direct relationship with a company’s taxable income.
Inventory can be valued in multiple ways but there are three popular methods used by most companies that have layers of inventory to deal with.
- First In, First Out (FIFO) – assumes that inventory produced first will be the first to be sold. For example, lets assume that a company produces widget-x and the cost to make these widgets changes depending on raw material costs. The company produces 50 units of widget-x for a cost of $5 a piece this week and another 50 units of widget-x for a cost of $7 next week. Lets also assume that two weeks from now the company sells 70 units to a retailer. Under FIFO, the cost of goods sold that will be reported on the income statement will consists of the 50 units from the first week at $5 a piece + 20 units from the second week at $7 a piece for a total of $250 + 140 = $390. If one were to prepare a balance sheet at the end of the third week, inventory will be valued based on the remaining 30 units from the second week at $7 a unit for a total of $210.
- Last In, First Out (LIFO) – assumes that the most recently produced inventory will be the first to be sold. Using the same information from the FIFO example, lets see how LIFO changes things. On the third week when the sale is made, cost of goods sold reported on the income statement will consist of the most recent 50 units from layer 2 priced at $7 a unit + 20 units from layer 1 priced at $5 a unit for a total of $350 + $100 = $450. Assuming that the balance sheet is prepared at the end of the third week, inventory will be valued based on the remaining 30 units from the first week at $5 a unit for a total of $150.
- Average Cost – takes the average of the various layers of inventory and uses one amount for all reporting purposes. Using the same example as the previous two methods, lets see how Average Cost changes things. At the end of the second week layer one’s value is 50 units x $5 per unit = $250. Layer two’s value is 50 units x $7 per unit = $350. So overall there are 100 units in inventory worth a combined total of $600. When 70 units are sold during week 3, the average cost of the 100 units available ($600/100 = $6 per unit) for sale is used to report the cost of goods sold. At $6 a piece the sale of 70 units will result in COGS of $420 and the remaining 30 units reported on the balance sheet will be valued at 30 x $6 = $180.
For the most part, choice of the method used depends on the nature of business, general economic conditions and business trends. For example, it wouldn’t make sense for a producer of perishable items like milk or cheese to use the LIFO method because that would not be a fair representation of the true flow of inventory. Certainly as an operator of such a business you’d hope to have the older of what is produced sold first.
But for those that are able to use LIFO, they can benefit from a reduction in tax liability because cost of goods sold is usually higher (where inflation exists) and taxable income therefore is lower. However, the representation on the balance sheet can be somewhat misleading especially if the older product‘s acquisition or manufacturing cost was significantly lower or if the inventory is potentially seen as obsolete.