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written by | May 2, 2022

What is Inventory Valuation, and Why is it Important?

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Inventory valuation is an accounting process businesses use to determine the value of unsold inventory items when generating their financial accounts. Inventory makes up a significant amount of the assets of any firm that sells tangible goods, and therefore it's critical to keep track of its value. A deep understanding of inventory valuation can aid in maximising profits, and it also assures that its inventory value is appropriately represented in its financial accounts.

Businesses can use this amount to calculate their inventory turnover ratio, which can help you plan your purchases. The accounting treatment for inventories is provided by Ind AS-2 and AS-2, particularly in terms of their measurement and disclosure. The technique used to value inventories can impact a company's gross profit within a given accounting period.

Did you know?

Inventory valuation directly impacts COGS, i.e. Cost of Goods Sold and is an important factor in measuring your company's overall financial health.

Also Read: Everything You Need to Know about Inventory Costing Methods

What is Inventory Valuation?

The monetary amount associated with the goods in inventory at the end of an accounting period is known as inventory valuation. The price is determined by the costs of acquiring the goods and preparing it for sale.

The largest current business assets are inventories. Inventory valuation helps you assess your cost of goods sold (COGS) and, as a result, your profitability. FIFO (first-in, first-out), LIFO (last-in, first-out), and WAC are the most commonly utilised valuation methodologies (weighted average cost).

Why is Inventory Valuation Important?

Inventory valuation provides precise metrics utilised to make strategic decisions and prepare accurate financial accounts. Following a thorough inventory assessment, a more informed decision can be taken on many firm parts.

The list given below includes all the reasons why the valuation of the inventory is advisable for every business:-

Impact on COGS

There is much less expensive to charge the Cost of Products Sold when closing inventory has a higher valuation and vice versa. As a result, the profit levels stated are heavily influenced by inventory valuation.

Impact on Ratios Relevant to Loan Finance

If a business has obtained a loan from a lender, the loan agreement may restrict the allowable proportions of current assets to current liabilities. If the entity fails to meet the target ratio, the lender can call the loan. Because inventory is often a large component of this current ratio, inventory valuation is critical.

Impact on Income Taxes

The cost-flow technique utilised can affect the amount of taxes paid. During heightened prices, the LIFO technique is often employed to reduce the income taxes paid.

Impact on Multiple Periods

Because the incorrect ending balance in the first period will be incorrect, it will carry over into the beginning inventory balance in the next reporting period, causing the reported profits in two consecutive quarters to be incorrect.

Objectives of Inventory Valuation

The ultimate purpose of inventory valuation is to assist in the formulation of an accurate picture of a firm's total profit and financial situation. The gross profit of a corporation is determined by deducting the Cost of Goods Sold (COGS) from net sales (total sales, fewer returns and discounts, and any other income not related to sales).

How a company assesses its inventory directly affects its gross profit and income statement, which banks and investors use to evaluate financial performance. The value of inventory impacts a company's balance sheet, which reflects the company's assets and liabilities. Inventory, together with cash, short-term investments, accounts receivable, supplies and prepaid insurance, is considered a current asset for accounting purposes.

Different Inventory Valuation Methods

The inventory valuation technique is a method for calculating the overall value of a company's inventory at any given time. The inventory value is computed using the total cost of purchasing and preparing the inventory for sale. This is critical in accounting because the valuation of any item is used to calculate the Cost of Goods Sold, which directly impacts the income statement and balance sheet.

The most popular methods of inventory valuation are as follows:- 

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

According to the First-In-First-Out (FIFO) value strategy, inventory products are sold in the same order as purchased or manufactured. The oldest inventory products are sold first, according to the FIFO principle. The FIFO value method is the most often used inventory valuation method since most companies sell their products in the same order that they buy them. There are two fundamental drawbacks of FIFO. For starters, a larger gross income means a higher tax burden. Second, FIFO can lead to financial statements that are misleading to investors during periods of strong inflation.

2. Last In, First-Out (LIFO)

This inventory valuation approach is the opposite of the First-In-First-Out (FIFO) inventory valuation method. It is assumed that the products purchased or manufactured most recently are sold first. LIFO allows for a more precise match between expenses and revenue. It also lowers the company's tax bill while increasing COGS.

3. Weighted Average Cost (WAC)

Inventory and Cost of Goods Sold (COGS) are determined using the Weighted Average Cost inventory valuation method, which uses the average cost of all things purchased over a period. This strategy is primarily employed by businesses that do not have inventory variances.

Also Read: Learn About Safety Stocks

Examples of the above 3 methods of inventory valuation

Items

Units

Rate per unit

Apr

100

20

May

200

30

June 

350

45

Items Purchased

500

 

Items Sold

350

 

Items unsold

100

 

Now the value of purchases is ₹23,750 (100*20 200*30 350*45)

The value of inventory under the three methods will be as follows:-

  1. FIFO – Items bought will be sold first. The value of sales will be ₹10,250 (100*20 200*30 50*45). Now the closing stock will be ₹23,750₹10,250 = ₹13,500.
  2. LIFO – Items bought will be sold first. The value of sales will be ₹15,750 (350*45). Therefore, the closing stock will be ₹23,750₹15,750 = ₹8,000.
  3. Weighted Average Cost – The total value of purchases is divided by the total number of units to get the average cost.

Average Cost = ₹23,750/500 = ₹47.5

Sales = 350*47.5 = ₹16,625

Closing Stock = ₹23,750₹16,625 = ₹7,125.

Choosing the Right Inventory Valuation Method

There are no hard rules for which valuation method is best for a particular business, but let's look at the advantages and disadvantages of each method:

• At the moment, FIFO yields the grossest income, LIFO the least, and WAC somewhere in the centre.

This is based on a standard inflationary scenario in which supplier costs rise over time.

As a result, FIFO has the highest tax burden, while LIFO has the lowest, with WAC in the middle.

• LIFO is permissible under the US Generally Accepted Accounting Principles (GAAP) but not by International Financial Reporting Standards (IFRS) (IFRS).

As a result, while LIFO is available in the United States, it is not in many other countries.

LIFO can match current income with recent costs, reducing the effects of inflation and deflation.

• The apparent solution is to use a specific ID when you, your shareholders or your clients want to know the cost and the selling price of each unit.

People who purchase and sell art may be interested in how the price of a Rembrandt changed from when it was last purchased to when it was sold.

Challenges of Inventory Valuation

When valuing inventory, there are two primary challenges: the company must estimate the overall cost of its inventory, and to do so, it must first figure out how much inventory it has, which can be difficult.

Keep Track of Your Inventory Costs

The following is the basic equation for calculating the value of your remaining inventory at the end of an accounting period:

COGS = Opening Stock Purchases – Closing Stock.

Now,

Closing Stock = Opening Stock Purchases – COGS.

The importance of beginning and ending inventory, on the other hand, may not be as straightforward as it appears. Anything you can't sell for full price due to damage, obsolescence or simply shifting consumer tastes needs to be marked down and valued properly.

Determining the Amount of Inventory

This can also be more difficult than it may seem, and it may also be necessary to undertake physical inventory counts. A periodic inventory system is used by many businesses to keep track of goods, and companies use this technique to evaluate inventories after each accounting period. On the other hand, a perpetual inventory system tracks every purchase order and sale and changes inventory to reflect those activities constantly.

Conclusion

The Cost of Goods Sold (COGS), gross income and the monetary worth of inventory remaining at the end of each period are affected by how a company values its inventory. As a result, inventory valuation impacts a company's profitability and future value, as shown in its financial accounts.

It's also crucial to choose an inventory valuation method since once a corporation has decided, it should generally stay to it.
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: How do you calculate closing stock?

Ans:

Opening stock net purchases: COGS = closing stock is the basic formula for calculating ending inventory. The closing stock of the previous period is your starting inventory, and the products you've purchased and added to your inventory count are net purchases.

Q: Why is FIFO the best method?

Ans:

When utilised in an industry where the price of a product is stable, and the company sells its oldest products first, FIFO is most successful. Because FIFO is predicated on the cost of the first item purchased, it ignores any price increases or decreases for newer units.

Q: How to calculate inventory value using the weighted average cost method?

Ans:

According to the Weighted Average Cost approach, the value of closing inventory should be calculated using the average price of inward inventory values. The following is the formula:

Average cost per unit = Total inward value / Total inward quantity.

Q: When is the inventory valuation accounted for?

Ans:

Each inventory is evaluated at the end of a particular reporting period.

Q: Can you change your inventory valuation midway?

Ans:

While changing your method during your business cycle is doable, it can be a time-consuming and laborious procedure. The approach, however, cannot be modified in the middle of a business cycle year.

Q: What is included in valuing inventory?

Ans:

Inventory value takes into account a wide range of expenses. All included are direct labour and materials, factory overhead, freight-in, handling and import duties or other taxes on inventory purchases.

Q: Is inventory valued at cost or selling price?

Ans:

In most cases, inventory is valued based on its cost. Calculating cost might be difficult depending on the type of business and the inventory valuation method employed. To figure out how much inventory the firm has at various production phases, the company must first figure out how much inventory it has.

Q: How is inventory valuation calculated?

Ans:

There are several methods for calculating the value of inventory. The main three methods are First In First Out (FIFO), Last In First Out (LIFO) and Weighted Average Cost (WAC).

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.