Managing inventory is one of the most challenging parts of being a retailer. It’s also one of the most important. If you don’t have good insight into how much your inventory is worth, it’s impossible to understand the financial position of your business.
By undertaking regular inventory valuation, retailers can build an accurate picture of how much their inventory is costing them over time — and how the value of this asset is affecting their tax obligations and profitability.
In this post, we’re going to define what inventory valuation is and the different inventory valuation methods that retailers can use for the purposes of inventory accounting.
What is inventory valuation?
The majority of retailers will have a lot of capital tied up in their inventory (especially if they’re using a Just in Case [JIC] inventory management model) so it’s important to understand the value of your current assets and how they affect your profitability.
Inventory valuation is a key part of inventory accounting that enables you to calculate the value of your unsold inventory. Understanding inventory value is an important part of preparing end-of-year financial statements, such as for cash flow and tax purposes.
In sum, the purpose of inventory valuation is to understand your total gross profits, which are impacted by the total Cost of Goods Sold (COGS). Depending on how your inventory is valued and the cost flow assumption you use, this will either inflate or deflate your profits.
To value your inventory properly, you need to take into account all of the costs that attribute to acquisition and getting goods ready for sale in addition to the purchase price (excluding indirect costs such as marketing or administration). This includes:
- Raw materials
- Warehouse utilities (e.g. water, power, climate control)
Understanding how much your inventory items are worth helps you to determine future purchasing decisions and whether your current inventory management strategy is working for your business. There are multiple methods of inventory valuation to help control fluctuations in the market rate of your inventory, though the most suitable technique will depend on the nature of your business.
Why is inventory valuation important in retail?
Evaluating COGS. COGS will differ depending on which inventory valuation method your retail business uses. The higher the valuation of ending inventory, the less you can attribute to the cost of goods sold. This is why it’s important to ensure that you’re valuing your inventory accurately, or this could affect your overall profitability.
Making the right decision of markdowns/restocking. To price your products effectively and earn a decent profit margin, you need to know how much your inventory is costing you. This also affects decisions surroundings markdowns, in the case you have excess inventory you need to shift before depreciation kicks in. Using the right inventory valuation method enables you to calculate the minimum profit margin your business can accept.
What are the different inventory valuation methods and how do they work?
It’s important to note that the use of a certain inventory valuation method for accounting purposes differs from using it as an inventory system. For example, it’s not necessary for a business to literally sell products on a first in, first out basis in order to use FIFO for inventory valuation.
The LIFO method (Last In First Out)
Last in, first out is a technique that assumes that the first items to enter your inventory will be the first to be sold. The model conceptualizes a proverbial store shelf as filled with busy activity at the front i.e. the new products going in, while products at the back i.e. older inventory remain untouched.
Pros: Using LIFO costing comes with significant tax advantages for retailers. Because it takes into account how the market value of inventory is likely to rise over time, it ensures that the bulk of your inventory i.e. your oldest beginning inventory carries more weight than more expensive, remaining inventory. For reporting purposes, this raises COGS and lowers gross profits, resulting in lower income taxes for the business owner.
Cons: The LIFO method is a far less intuitive method of inventory valuation. Very few businesses see their inventory move in this way, as it would result in copious quantities of dead stock. For this reason, LIFO is banned under International Financial Reporting Standards (IFRS) though it’s permitted by the Internal Revenue Service (IRS) under generally accepted accounting principles (GAAP).
The FIFO method (First In First Out)
FIFO is the opposite of LIFO by assuming that your oldest inventory is sold first. It’s generally the most straightforward inventory valuation method for retailers to use, since it most closely matches the actual cost of inventory and inventory movement.
Pros: FIFO is the most commonly used inventory valuation method. FIFO normally results in higher gross profits because the cost of acquiring inventory typically rises over time. This keeps your COGS lower and creates a healthier income statement.
Cons: The biggest downside of FIFO is that because your net income appears higher, the income taxes owed for that accounting period will be higher also. In periods of high inflation, FIFO can also distort the true value of your inventory.
WAC (Weighted Average Cost Method)
WAC takes the average of all inventory costs in order to find the average, rather than giving weight to newer or older inventory as FIFO and LIFO do. WAC is most appropriate for retailers who are selling a large number of identical or very similar items.
Pros: WAC avoids a business having to track the cost of separate inventory purchases, which is advantageous for businesses that don’t have a sophisticated inventory management system. It also helps to even out the fluctuations in the cost of a company’s inventory at the time of purchase.
Cons: The main disadvantage if Weighted Average Cost is that if there are large price fluctuations during the accounting period, you’re likely to get an inaccurate figure on your balance sheet that results in products being sold at a loss.
The Specific Identification Method
The Specific Identification Method is the opposite of WAC because it tracks the specific cost of items in your inventory. This is only possible if a business is using serial numbers of RFID tags to label units, meaning it’s best-suited to retailers who are selling specialist or one-of-a-kind items that require authentication.
Pros: Specific Identification Method is a perpetual inventory system that offers the highest accuracy of any inventory valuation method (a major advantage when inventory is only accurate 63% of the time). This means it’s possible to track the exact purchase cost and additional selling costs, and therefore estimate profitability.
Cons: Every single item in your inventory isn’t feasible for larger businesses or businesses that sell thousands of identical products, as this is very time-consuming and requires advanced inventory management capabilities.
Which inventory valuation method is best for your retail business?
Choosing the most suitable inventory valuation method for your retail business depends on several different factors such as:
- What you’re selling
- How much the price of your stock is fluctuating
- Whether you’re planning on applying for business loans
- Whether you’re trying to attract investors
When to use FIFO: FIFO results in much higher inventory valuation than either LIFO or WAC. This is favorable if you have an eye on bringing investors into your business or applying for a loan in the near future.
When to use LIFO: LIFO is the best option for financial accounting purposes during periods of high inflation, since it puts more weight on older and cheaper inventory. It also results in a lower tax bill. It’s important to note that if prices are decreasing, the ‘lower of cost’ or market value rule should be applied for valuation purposes
When to use WAC: If you’re a business with more or less identical inventory, such as a retailer selling different size and color variations of the same products, WAC will make inventory valuation much less stressful, but at the cost of making your gross profit less accurate.
When to use Specific Identification Method: If you’re selling couture or one-of-a-kind products, Specific Identification is a tailored enough approach to record the accurate valuations necessary to record appreciation over time.
Inventory is one of the biggest pieces in the puzzle of being a retailer, and it’s critical that you choose the right valuation strategy to empower your business towards stronger growth and profits. By using one of the four inventory valuation methods outlined above, you can get a firm grasp on your business’s profitability and be better. informed when making key decisions about the future of your brand.
About Francesca Nicasio
Francesca Nicasio is Vend’s Retail Expert and Content Strategist. She writes about trends, tips, and other cool things that enable retailers to increase sales, serve customers better, and be more awesome overall. She’s also the author of Retail Survival of the Fittest, a free eBook to help retailers future-proof their stores. Connect with her on LinkedIn, Twitter, or Google+.