What Is Inventory Valuation | Important | Objectives | Identification 2021:- Every company that sells physical goods needs to determine the value of its inventory for accounting purposes. Since inventory typically accounts for a large portion of business assets, the way it’s valued can significantly affect the company’s profits, tax liability, and asset value.
What Is Inventory?
For a company that manufactures or sells physical goods, inventory includes everything that goes into those products, such as raw materials, work-in-progress and finished goods. Consider the example of a company that makes coffee filters and ships them to retailers for sale to consumers. After manufacturing the filters, it needs to package them into the boxes of 50 filters that you see on the supermarket shelf. So in addition to the finished filters and the paper used to make them, the company’s inventory includes the cardboard boxes it uses to ship those items to retailers.
If the company also makes the packaging instead of buying it from someone else, its inventory includes the printed cardboard not yet assembled into package form, as well as the glue used to make boxes. Manufacturing the packages might be a multi-step process, so the company might have piles of half-made coffee filter packages sitting around. Those are inventory, too.
What Is Inventory Valuation?
Inventory valuation is the accounting process of assigning value to a company’s inventory. Inventory typically represents a large portion of the assets of any company that sells physical items, so it’s important to measure its value in a consistent manner. A clear understanding of inventory valuation can help maximize profitability. It also ensures the company can accurately represent the value of inventory on its financial statements.
What Are the Objectives of Inventory Valuation?
The overall objective of inventory valuation is to help create an accurate picture of a company’s gross profitability and financial position. To calculate the gross profit listed on the company’s income statement, a company must subtract the cost of goods sold (COGS) from net sales (total sales — returns and discounts and any other income not related to sales). The basic formula for COGS at the end of any accounting period is:
COGS = Beginning inventory + Purchases – Ending inventory
As a note, COGS includes the direct cost of materials and labor required to create the good and doesn’t include indirect expenses such as marketing and distribution.
Therefore, the method a company uses to value its inventory directly affects its gross profit and income statement, which gives banks and investors an idea of financial performance. Inventory valuation also affects a company’s balance sheet, which lists the company’s assets and liabilities. Inventory is treated as a current asset for accounting purposes, along with cash, temporary investments, accounts receivable, supplies, and prepaid insurance.
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Which Inventory Valuation Method Is Best
Choosing the right inventory valuation method is important as it has a direct impact on the business’s profit margin. Your choice can lead to drastic differences in the cost of goods sold, net income, and ending inventory.
There are advantages and disadvantages of each method. For example, the LIFO method will give you the lowest profit because the last inventory items bought are usually the most expensive while the FIFO will give you the highest profit as the first items in stock are usually the cheapest.
To assess the method which is best for you, you need to pay attention to changes in the inventory costs.
- If the inventory costs are escalating or are likely to increase, LIFO costing may be better. As higher-cost items are considered sold, it results in higher costs and lower profits.
- In case your inventory costs are falling, FIFO might be the best option for you.
- For a more accurate cost, use the FIFO method of inventory valuation as it assumes the older items that are less costly are the ones sold first.
As a business owner, you need to analyze each method and apply the method that reflects the periodic income accurately and suits your specific business situation. The Financial Accounting Standards Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and LIFO accounting.
It is also important to note businesses cannot switch from one method of inventory valuation to another. If your business decides to change to LIFO accounting from FIFO accounting, you must file Form 970 with the IRS.
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