Inventory valuation is very important for companies, as it is a major portion of assets and part of the balance sheet. So the company should valuate the inventory with most care and aware of the the valuation methods that suitable to their business environment.
When an inventory item is sold, the inventory account should be reduced (credited) and cost of goods sold should be increased (debited) for the amount paid for each inventory item. This works if a company is operating under the Specific Identification Method. That is, a company knows the cost of every individual item that is sold.
The inventory valuation method gives 2 important values 1) Cost of Good Sold (COGS) and 2) Ending Inventory. COGS shows on the Income Statement, while Ending Inventory shows on the Balance Sheet. Company inventory value can be determined as
Ending Inventory = Beginning Inventory + Purchases – COGS
There are three inventory-costing methods that are widely used by both public and private companies (Argus Inventory Software supports):
1. First-In, First-Out (FIFO) - This method assumes that the units sold are oldest units on hand.
2. Last-In, First-Out (LIFO) - This method assumes that the units sold are newest units on hand.
3. Average Cost - This method assumes that the weighted average of all units available for sale
Importance of Inventory Valuation
When dealing with inventory items, we know the market shows different trends in trading of various products. The prices tend to increase or decrease, which means the choice of valuation method can dramatically affect ending inventory.
If prices are increasing, each of the valuations methods produces the following results:
- FIFO gives us a better indication of the value of ending inventory (on the balance sheet). It also increases net income because less cost old inventory is used to value the cost of goods sold. But should note that increase the amount of taxes that a company must pay.
- LIFO is not a good indicator of ending inventory value because the left over inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.
- Average cost produces results that fall somewhere between FIFO and LIFO.
If prices are decreasing then the complete opposite of the above is true.
