Often, businesses focus on inventory management from a supply chain perspective – holding enough stock to meet customer demand and hitting fulfilment targets. This post, however, will focus on the financial aspect of inventory: inventory value – taking an accountant’s view of how to manage stock effectively.
Inventory value shows how much unsold inventory is worth at the end of a company’s accounting period. It shows a company’s gross profitability and current financial position.
Inventory value will change over time – usually reducing. As demand falls and items become obsolete, inventory will need to be discounted to make way for new stock items. Therefore, it’s necessary to keep track of the value of inventory in your business.
For businesses that hold stock, inventory usually accounts for a large proportion of their assets. Therefore, understanding inventory value can directly impact gross profit and tax liability.
Due to the likelihood of price fluctuations across an accounting period, inventory valuation provides one reference point for accounting purposes.
Inventory value appears as a current asset on a company’s balance sheet and forms a key part of the cost of goods sold (COGS) calculation.
When inventory value at the end of an accounting period is high, this leaves less expense to be charged to the cost of goods sold and vice versa. It therefore has a major impact on reported profit levels.
Inventory value is needed to calculate cost of goods sold.
When calculating inventory value, you should include all costs relating to acquiring and getting an item ready for sale. This can include direct labour costs, direct materials, attributed overheads, freight or import duties. Inventory value doesn’t include distribution or sales costs – only costs to get the item ready for sale.
With this data, you can then calculate COGS using the following formula:
Purchases during the period is the total of your purchases during the current accounting period.
Ending inventory is what you have left unsold at the end of the current accounting period.
COGS can help you understand your profits for the accounting period and whether your prices need adjusting. It can also identify if you need to reduce your production costs.
Before calculating inventory value, you need to understand what unsold inventory you hold. You can then use one of the four inventory valuation methods below.
The FIFO method sees inventory sold in the order it comes into the warehouse, i.e., the oldest inventory gets sold first. This means that the costs of the oldest items are recorded on the balance sheet. Where prices are high, this will show a low cost of goods sold but higher reporting profits and taxes.
The LIFO method is where a company sells the last inventory items into the business first. This will show the most recent inventory charges on the balance sheet as the cost of goods sold. Where prices are high, this will reduce profits and tax liability.
Lower taxes make this an appealing method, but LIFO can increase the chances of holding obsolete stock. Obsolete stock can lead to writing off stock or selling at a heavy discount.
Using the WAC method means that a company doesn’t look at which items they sell first. It takes an average of the cost for all inventory items.
Calculating the weighted average cost can be easy for a company and can usually be done by an inventory management system. It also means that the cost of goods sold isn’t affected by any price increases or variations. It represents the actual cost of inventory items.
The specific indication method is not used as often, as it suits companies that sell unique inventory items. They will need to track each item’s specific cost rather than group items together.
Choosing the right inventory calculation method will depend on your company’s situation, goals and objectives. It will also depend on external factors, such as economic, market and supply conditions.
Some things to consider are:
• To show a high stock value, for example, to use your stock as collateral, the FIFO method would be best.
• Where you need to show a high profit margin, for example, to bring in investors, FIFO or LIFO could work. The FIFO method would work better where prices are high; LIFO where prices are low.
• Where you need to pay lower taxes, LIFO will show a lower profit margin where prices are high.
While your business strategy might change to respond to market conditions, it’s important to maintain consistency in inventory valuation methods. Changing too regularly will confuse results and potentially void the inventory value figure.