Inventory is the heart and soul of any retail store. Without inventory, there are no sales. And as a retail manager or owner, having an accurate picture of inventory valuation is paramount to planning your purchasing decisions and avoiding situations such as dead stock or excess inventory.
Inventory is an asset to an organization, and to be recorded on the balance sheet, it must have a financial value. Inventory valuation affects a company’s profitability and its potential value, as reported on its financial statements.
In this article, you’ll learn more about the different inventory valuation methods and key factors that play into choosing the best inventory valuation strategy for your business.
Table of Contents
- What is an inventory valuation?
- What Is the importance of inventory valuation in retail?
- What are the different inventory valuation methods, and how do they work?
- Which inventory valuation method is best for your retail store?
What Is Inventory Valuation?
Inventory valuation is the accounting process of determining the cost associated with all unsold inventory at the end of a reporting period. Measuring the value of merchandise and knowing how it affects the business’s profitability is essential. Understanding inventory valuation helps keep your company’s financial statements accurate and up-to-date.
In addition, it should be noted that the inventory valuation method you use also comes with certain tax implications. The IRS requires that you stick to one method, such as the first-in, first-out (FIFO), or weighted average cost (WAC) method, in your first tax year. If you plan to change your inventory valuation approach in subsequent years, you must notify the IRS, which must grant you permission. Such a rule is intended to prevent tax fraud.
Proper valuation of your inventory involves considering all prime costs attributable to acquiring and preparing the goods for sale and the purchase price (excluding indirect costs such as marketing or administration). These costs include labor, taxes, transportation, etc.
There are many methods of inventory valuation to help control fluctuations in the market price of your inventory. However, the most appropriate method will depend on the nature of your business.
See Also: How to Calculate Gross Profit Margin
What Is The Importance of Inventory Valuation In Retail
The purpose of inventory valuation is to provide an accurate picture of a company’s gross profitability and financial position. Gross profitability on a company’s income statement is determined by subtracting the cost of goods sold (COGS) from net sales (total sales – returns and rebates and any other non-sales-related income).
Part of why inventory valuation is so important is because inventory management is becoming more onerous for retail merchants. Estimates show that by 2024, retailers will be exposed to a shortage of 140 million square feet of storage, increasing the cost of warehousing. As a result, retail stores will need to control inventory better.
In addition, the need to use automated inventory management software will be ever more apparent. An accurate grasp of your inventory’s valuation will allow you to make more informed decisions regarding your suppliers or manufacturers and whether to increase or decrease warehouse space. There are some other benefits of inventory valuation, too:
On your company’s balance sheet, inventory is listed as an asset. You invest money to buy or create your products and future sales, then turn the investment into revenue. If you want to apply for a loan, lenders will look at the value of the ending inventory on your balance sheet before approving it. Higher valuations give the lender more confidence that you will repay the loan.
In addition, lenders may restrict the allowable proportion of current assets to current liabilities, known as the loan ratio. The lender may require prepayment if you can’t meet the target ratio. Since inventory is often the most significant component of loan ratios, tracking the value of your inventory can help you meet the target ratio.
Influence on taxes
Your choice of inventory valuation method is directly related to how you report your taxes. For example, the first-in, first-out (FIFO) method will produce more taxable income than the last-in, first-out (LIFO) method. Using the correct valuation method, you can ensure that you pay the right amount of taxes and avoid an IRS audit.
What Are The Different Inventory Valuation Methods, And How Do They Work?
There are primarily four inventory valuation methods that you can apply as a retail business owner. However, it is worth noting that using a certain inventory valuation method for accounting purposes differs from using it as an inventory system.
The LIFO (Last-In, First-Out) Method
The LIFO method is one of the most common inventory valuation methods used in retail. It is based on the principle that the goods produced or acquired last are the first to be sold. In other words, the most recently purchased items in your inventory will be the first to be sold. LIFO allows a company to benefit from a lower tax rate because it makes less profit, which can ultimately be beneficial to the bottom line. On the other hand, LIFO is not ideal for brands that are expanding internationally, as it is only legal in the United States.
Advantages of the LIFO method
- Reduces the income tax bill in times of inflation
- Less inventory write-downs
- Brings revenues in line with costs
- Ideal for companies with rising raw material and labor prices
- Not recommended for perishable or time-sensitive products such as convenience stores or grocery stores
Disadvantages of the LIFO method
- Much less intuitive and challenging to maintain
- Requires complex record keeping
- Not approved by International Financial Reporting Standards (IFRS)
- Lowers the value of the final inventory
The FIFO (First-In, First-Out) Method
Unlike the LIFO method, FIFO is the most common method of inventory valuation for retailers. It is based on the premise that the oldest items in your inventory are sold first. This inventory valuation strategy is ideal for businesses that operate in an industry where product prices remain stable.
Benefits of the FIFO method:
- Saves businesses time and money by calculating the exact cost of inventory
- Easy to understand and apply
- Widely used and accepted method of valuation
- Makes it difficult to manipulate revenue reported in financial documents
- Increases gross and net profits in times of rising commodity prices
- It can be applied to all types of commodities
- Reduces the risk of high holding costs for dead stock storage
Disadvantages of the FIFO method
- Not ideal if the price of goods fluctuates
- Not helpful in times of inflation as it results in higher net income than LIFO
WAC (Weighted Average Cost Method)
The weighted average cost method is the middle ground between LIFO and FIFO. It involves taking all inventory costs to find the average rather than giving weight to newer or older inventory.
To determine the weighted average cost, divide the total cost of goods purchased by the number of units available for sale. The weighted average cost method is most suitable for businesses that sell many identical or very similar items. It simplifies inventory costing and avoids tracking the cost of individual inventory purchases when calculating profit and tax liability.
Advantages of Weighted Average Cost (WAC)
- Reduces fluctuations in profit due to the timing of purchases and sales.
- Eliminates the need for a company to track the cost of separate inventory purchases
Disadvantages of the Weighted Average Cost (WAC)
- Not as sophisticated for tracking LIFO and FIFO inventories
- You can get inaccurate figures on your balance sheet if there are large price fluctuations during the accounting period
This inventory valuation method is a system of tracking individual items from the time they enter the inventory until they are sold. Each product is tagged with its cost and any additional costs incurred until it is sold. The specific identification method is only possible if a company uses RFID tags to label units with serial numbers or stamped receipt dates. This means it is best suited for retailers who sell specialty or unique items that require authentication.
Benefits of specific identification
- Provides the highest accuracy of any inventory valuation method
- Easy to track exact purchase cost and additional selling costs and, therefore, estimate profitability
Disadvantages of specific identification
- It requires a detailed physical count.
- It is complicated to account for every item in their inventory for large companies or companies that sell thousands of identical products
- Time-consuming, and it requires more advanced inventory management
Which Inventory Valuation Method Is Best For Your Retail Store?
There are no direct answers to this question. The best inventory valuation strategy for your retail business will depend on several factors. Market conditions and your company’s financial goals will determine the method that will work best for you. The following scenarios can help you determine the best inventory valuation technique for your business.
1. Seeking a Business Expansion Loan
If you plan to apply for a loan, you will need to hold your inventory as collateral. In this case, it is best if your inventory value is high, as a higher valuation will give the lender more confidence.
For example, if prices rise throughout the year, a FIFO inventory valuation technique will give you a higher value for the final inventory. A LIFO technique will give you a higher value if prices are falling.
The ending inventory value on your balance sheet is one of the factors used by financial institutions before approving a loan to a business, so the technique that gives you the highest inventory value will be the best for your business.
2. Market Conditions
The cost of purchasing or producing inventory can change quickly based on various economic factors. Therefore, it is imperative to consider these different market conditions when determining a valuation method.
If, during the year, prices increase, the FIFO method will result in a higher value for ending inventory. But it’s not acceptable to change the valuation technique during the year. You’ll have to recalculate the value of your inventory, which may result in inaccurate counts and impact your balance sheet. Also, as mentioned earlier, you cannot make a change in the method without notifying the IRS.
Choosing the right inventory valuation strategy is critical to assessing inventory levels and facilitating tax reporting and financial analysis. FIFO and WAC methods are excellent ways for many retailers to determine inventory value and easily keep accurate records.
However, you must remember that inventory valuation is not enough for better inventory management. Investing in automated inventory management software gives you an accurate picture of your inventory and helps you make proper inventory management decisions.
KORONA POS, an inventory management software specifically designed for retail businesses, allows you to streamline your inventory with features that are perfectly customizable for your business. KORONA POS inventory tracking software automatically detects problems and allows you to prioritize products that are in negative stock or selling less.
Likewise, KORONA POS can adjust the appropriate permissions for certain users. You can have your staff perform counts without giving them full access to your inventory and values. If you want to learn more about KORONA POS, click on the button below for a demo with one of our product specialists.
FAQs: Inventory Valuation Strategies
There are four accepted methods of inventory valuation. These are First-In, First-Out (FIFO),
Last-In, First-Out (LIFO), Specific Identification, and Weighted Average Cost.
There is no single best method of inventory valuation. Instead, the best method of inventory valuation depends on the business. Companies consider many factors such as financial goals, market conditions, company size, etc. However, for many retailers, FIFO and WAC are excellent ways to determine the value of inventory and easily keep accurate records.
Inventory value can be calculated by multiplying the number of items in inventory by the unit price of the items. In accordance with GAAP, inventory valuation should be calculated based on the lower of the market price or cost to the company.
Under the LIFO method, the most recently purchased products (or items) are the first to be sold. The LIFO method is used only in the United States and is governed by generally accepted accounting principles (GAAP) which are beneficial for companies that do not have a sophisticated or advanced inventory management system.