Top 4 Inventory Valuation Methods Explained with Examples

Inventory valuation is essential for accounting and financial reporting purposes. The method by which a business values its inventory can impact several other key aspects, including cost of goods sold (COGS), gross profit, applicable taxes, and the balance sheet. According to accounting standards, having the correct method and applying it consistently is crucial. 

In this article, we will examine the top four inventory valuation methods, accompanied by relevant examples.

What Does It Mean By Inventory Valuation?

Inventory valuation is essentially the accounting process of assigning a monetary value to a company’s assets, including its stock. In simple terms, inventory valuation determines how much your inventory is worth at a given point in time. 

• On the balance sheet, inventory is recorded as a current asset.
• On an income statement, the cost of inventory sold during a period is recorded as Cost of Goods Sold (COGS), which impacts gross profit.

Why Inventory Valuation Methods Matter?

Inventory valuation has several benefits, such as:

• Inventory is often one of the most significant current assets on a company’s balance sheet. Misvaluing inventory can distort both profit and financial ratios.
• With inflation (or deflation), different methods produce very different values for ending inventory and COGS, thus affecting net income.
• Standards (GAAP, IFRS) require the disclosure of the method used and consistency. If there is a change in the inventory valuation methods, it must often be disclosed and sometimes applied retrospectively.
• To assess the financial stability of a business for loan approval, it is based on the company’s balance sheet and the valuation of its inventory.
• Inventory valuation can also impact the tax a business pays.
• Correct inventory valuation can provide essential data that helps inform strategic decision-making for future purchases and effective inventory management.

What Are the Various Methods of Inventory Valuation?

Inventory valuation can be performed using different recognised methods, which will ultimately affect the Cost of Goods Sold (COGS), ending inventory value, and overall financial reporting in various ways. 

Here are 10 methods of inventory valuation that are widely used:

1. FIFO (First-In, First-Out): Assumes the oldest inventory is sold first, so the ending inventory reflects the most recent costs.

2. LIFO (Last-In, First-Out): Most recently purchased items are sold first; the ending inventory reflects the oldest costs. Allowed under US GAAP, prohibited under IFRS.

3. Weighted Average Cost / Average Cost Method: This method uses a weighted average of all the inventory costs, no matter if it is ending inventory or COGS.

4. Specific Identification Method: Tracks the actual cost of each item sold, ideal for high-value or unique goods.

5. Retail Inventory Method: Estimates inventory value using a cost-to-retail ratio, standard for retailers.

6. Lower of Cost or Market (LCM): In this method, the inventory is recorded at the lower of historical cost or market value to prevent overstatement.

7. Net Realisable Value (NRV): Here, inventory is valued at the estimated price minus costs to complete and sell.

8. Replacement Cost Method: This method values inventory at the cost to replace it; it is majorly used for insurance or risk assessment.

9. Standard Cost Method: The method uses predetermined standard costs for inventory, comparing actual costs to standards to record variances.

10. Gross Profit Method: This method estimates ending inventory based on historical gross profit percentages, often for interim financial reporting.

The Top Methods of Inventory Valuation: Examples Included

Businesses rely on various inventory valuation methods to determine key aspects, such as the cost of goods sold and the ending inventory value. Amongst the different inventory valuation methods, here are the top four that are mainly used by businesses:

1. FIFO ((First-In, First-Out)

Under the FIFO method of inventory valuation, older inventory is first sold out before new inventory is procured. Eventually, the ending inventory signifies the most recent purchase costs. This method aligns closely with the physical flow of goods such as food, perishable items, or cosmetics.

In times of inflation, the FIFO method of inventory valuation results in a lower cost of goods sold because older and cheaper inventory is sold first, leading to higher profits. However, this also means a higher taxable income compared to other methods, such as LIFO.

Let us understand this with an example:

These are the purchase inventory at different time periods.

If the company sells 250 units, then, as per the FIFO method of inventory valuation:

• The first 100 units sold are from the Jan 1 batch at $10 each = 100 x $10 = $1,000
• The following 150 units sold are from the Feb 15 batch at $12 each = 150 x $12 = $1,800

Hence, the COGS = $2,800.

Whereas, the ending inventory is:

• Remaining 50 units from Feb 15 batch = 50 x $12 = $600
• 100 units from May 1 batch = 100 × $15 = $1,500

So, the ending inventory = $2,100.

2. LIFO (Last-In, First-Out)

In the LIFO method of inventory valuation, it is assumed that the most recently acquired items are sold first, leaving the older inventory on the balance sheet. This method is mainly used in environments with rising prices, as it assigns the latest, higher costs to the Cost of Goods Sold (COGS).

While it may reduce tax liability, LIFO can make the balance sheet inventory appear understated, as older, lower-cost items remain in inventory.

Let us understand this with an example:

These are the purchase inventory at different time periods.

If the company sells 250 units, then, as per the LIFO method of inventory valuation:

• The first 100 units sold are from the May 1 batch at $15 each = 100 x $15 = $1,500
• The following 150 units sold are from the Feb 15 batch at $12 each = 150 x $12 = $1,800

So, the COGS = $3,300

Whereas, the ending inventory is:

• Remaining 50 units from Feb 15 batch = 50 × $12 = $600
• 100 units from Jan 1 batch → 100 × $10 = $1,000

Thus, the ending inventory stands at $1,600.

3. Weighted Average Cost Method (Average Cost Method)

In the average cost method of inventory valuation, the average cost of all inventory available for sale during a period is applied to both COGS and the ending inventory. This method smooths out price fluctuations over time, making it particularly useful for businesses with large volumes of homogeneous items where individual tracking is impractical.

Contrary to FIFO or LIFO, there is no specific flow of goods. It helps simplify accounting and also reduces the impact of sudden price changes. 

Let us understand this with an example:

These are the purchase inventory at different time periods.

• Total units available = 400
• Total cost = 100×10 + 200×12 + 100×15 = $4,900
• Weighted average cost per unit = $4,900 ÷ 400 = $12.25

If the company sells 250 units, then, as per the average cost method of inventory valuation:

• COGS = 250 × $12.25 = $3,062.50
• Ending Inventory = 150 × $12.25 = $1,837.50

4. Specific Identification Method

The specific Identification method of inventory valuation assigns the actual cost of every specific item sold to the Cost of Goods Sold (COGS). It is therefore the best inventory valuation method. This approach is ideal for high-value, unique, or easily distinguishable items, such as cars, jewellery, or artwork, where tracking individual units is feasible. 

This method provides highly accurate profit reporting. However, the drawback is its administrative burden, making it impractical for businesses with large volumes of identical items.

Let us understand this with an example:

This is the stock of 3 phones in the inventory.

If the store sells Phone A and Phone C:

• COGS = $500 + $600 = $1,100
• Ending Inventory = Phone B = $700

Which is the Best Inventory Valuation Method?

The choice of the best inventory valuation method for your business will depend on several factors, such as:

• The nature of the inventory.
• The cost volatility.
• Tax environment
• Regulatory environment
• Administrative capacity
• Financial presentation goals

For many businesses, a combination of FIFO or the Weighted Average method works. However, if there are exceptional items, then a specific identification method becomes more relevant.

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Conclusion

Inventory valuation is not just another accounting task; it is a strategic decision that will have an impact on various aspects of a business, such as profits, taxes, and financial reporting. The top inventory valuation methods include FIFO, LIFO, Weighted Average and Specific Identification. Each method has unique advantages tailored to your business’s specific requirements. The correct method can help to optimise profits, manage costs, and gain a competitive edge.

Suggested – 7 Inventory Management Techniques: Exploring FIFO, FEFO, and LIFO Methods

FAQs About Inventory Valuation Method

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