What is Inventory Valuation | Inventory Valuation Methods

Inventory valuation methods

What is Inventory Valuation | Inventory Valuation Methods

Inventory is the most significant asset of every manufacturing company as it directly impacts the Productivity & Profitability of the organization. Every manufacturing company maintains some amount of inventory. Therefore, companies must be vigilant about how much inventory they have on hand; as well as the financial value of the Inventory on hand. Because “Inventory is money sitting around in another form”. Let us now discuss What is Inventory Valuation? What are the Inventory Valuation Methods? and Importance of Inventory Valuation

What is Inventory Valuation?

When we speak about Inventory of manufacturing companies, it refers to the company’s goods in three stages of production:

  1. raw materials & consumables
  2. goods in production or work-in-progress, and
  3.  goods that are finished and ready for sale or finished goods.

At the end of the accounting period, all these combined together, form the closing stock/closing inventory of the manufacturing company. Inventory valuation is based on the amount spent to obtain the inventory and convert it into finished goods, ready for sale.

Inventory Valuation refers to the computation of financial worth or monetary value of the inventory on hand, at the end of the accounting period.  Inventory valuation is necessary to have accurate information on a company’s financial position.

Why Calculate Inventory value? What is the Importance of Inventory Valuation?

Every company must calculate the inventory value to know the cost of raw materials issued to production and the monetary value of raw materials in stock, work-in-progress, cost of finished goods available with the company at the end of the accounting period. This forms the basis of calculating inventory on hand and determining the financial position of the company.

How does Inventory Valuation help determine Financial Position of the company?                      Inventory is depicted as Current Assets in the Balance Sheet of the company. Only, when the value of the inventory is calculated precisely, it will reveal the correct financial position of the company, else it will be misleading.

What are Methods of Inventory Valuation? Examples of Inventory Valuation Methods

The 3 popular Inventory Valuation Methods are.

  • First in First Out (FIFO)
  • Last in First Out (LIFO)
  • Weighted Average Cost (WAC)

Each of these methods impacts the bottom line of the company in a different way. We will discuss each Inventory Valuation Method with examples in the following sections.

While discussing Inventory Valuation Methods, we are going to take the example of a manufacturing company. The cost of each unit of raw material was 5 for first 10,000 units of raw material. The cost of raw materials for next lot of 10,000 units was 7 each. Let us assume that the company consumed 15,000 units of raw material at the end of the month.

Now, let us see how Closing Inventory of raw materials is Valued in FIFO, LIFO & Weighted Average Methods.

1. First in First Out (FIFO)

As the name suggests, FIFO method implies that raw materials/inventory items are used for production and/or sold in the order that they were purchased or manufactured. It means the oldest items are used/sold first to avoid obsolescence and the newest are retained in inventory. This will show the actual flow of goods produced v/s  goods sold. Let us consider the example mentioned above to calculate the FIFO Inventory Value of raw material.

  • Total Cost of Raw Materials Purchased = (10,000 X 5) + (10,000 X 7) = 50,000 + 70,000 = 1,20,000
  • Raw Materials Used = (10,000 X 5) + (5,000 X 7) = 50,000 + 35,000 = 85,000
  • FIFO Closing Inventory Value of Raw Materials = (5000 X 7) = 35,000

 2. Last in First Out (LIFO)

As the name suggests, this implies that raw materials/inventory items are used for production and/or sold in the reverse order that they were purchased or manufactured. It means the newest items are used/sold first and the oldest are retained in inventory.  This is typically beneficial in an industry where the cost of production is rising. This means that raw materials/goods produced at lower costs will be retained in inventory. Let us consider the example mentioned above to calculate the LIFO Inventory Value.

  • Total Cost of Raw Materials Purchased = (10,000 X 5) + (10,000 X 7) = 50,000 + 70,000 = 1,20,000
  • Raw Materials Used = (10,000 X 7) + (5,000 X 5) = 70,000 + 25,000 = 95,000
  • LIFO Closing Inventory Value of Raw Materials = (5000 X 5) = 25,000

3. Weighted Average Cost (WAC)

In the weighted average cost method (WAC), the inventory is calculated on the average cost of all the materials acquired during the period. Let us consider the example mentioned above to calculate the Weighted Average Cost Inventory Value.

  • Total Cost of Raw Material Purchased = (10,000 X 5) + (10,000 X 7) = 50,000 + 70,000 = 1,20,000
  • Units Purchased = 20,000, Hence Cost Per Unit = 120,000/20,000 = 6/unit
  • Raw Materials Used = 15,000 X 6 = 90,000
  • WAC Closing Inventory Value of Raw Materials = (5000 X 6) = 30,000

How to determine the right inventory valuation method for your business?

Choosing the right inventory valuation method for your business depends on a number of factors such as:

  • Are the raw material prices determined by the market forces?
  • Do you observe seasonal fluctuations in raw material prices?
  • How often does your inventory requirement change (demand based)?
  • Are the cost of production showing an upward trend? and more…

Which Inventory Valuation Method you choose, will directly impact the profit margin, net income of the business, and the closing inventory of the business. Let us tabulate the calculations performed in all 3 Inventory valuation methods from the example above.

Particulars FIFO LIFO WAC
Raw Materials Purchased (20,000 Units) 120,000 120,000 120,000
Cost of Raw Materials Consumed (15,000 units) 85,000 95,000 90,000
Closing Stock Valuation (5,000 Units) 35,000 25,000 30,000

There is no simple answer to the question, which inventory valuation method is best for your business. It will depend on the business objectives of your company.

E.g. If you plan to expand your business in the near future, it makes sense to use FIFO valuation as it provides a higher valuation of your inventory. Higher inventory value is useful if you have to avail a loan and provide inventory as collateral.

Choosing the right inventory valuation method can be a little complicated. So please consult an expert to guide you in the right direction. 

Summary

Inventory Valuation is the monetary value or financial worth of your closing inventory.  There are 3 popular Inventory Valuation Methods: First in First Out (FIFO), Last In First Out (LIFO) & Weighted Average Cost (WAC).  Choose an inventory valuation method that suits your organization’s financial goals.

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