What is Inventory?

Before discussing the topic inventory valuation let’s discuss the meaning of inventory. In accounting, inventory is also known as stock. Inventory means all the finished goods, materials, merchandise that a business holds for the purpose of selling it in the market with the motive of earning profit.

Inventory is that asset which can be converted into cash within a short period of time. It is also said that inventory forms a link between the production and sale of the product.

For example – if ABC company is doing an online business of cookies, then the business uses vehicles to deliver products to their customers. So, in this case cookies are the inventory for the company ABC and not the vehicles that are used for delivery. Now, discuss inventory valuation.

Inventory or stock is a significant and important asset for every business, so a proper inventory management must be there because if there is an excess inventory in the business than it create many problems like storage problem, insurance and many more additional expenses, e.g. if a stock becomes obsolete then it will be a loss for a company.

Similarly, if there is a shortage of inventory then it can lead to loss for the business and at the same time it may be possible that business may lose some of their customers.

According to the accounting principle, inventory is recorded in the balance sheet at the purchase price, not at the price it is sold in the market.

 The number of items included in inventory are:

Inventory is generally inclusive of raw material, work-in-progress and finished goods.

• Raw material: It refers to those items that are used in the process of manufacturing goods or products. For example- In a bakery, flour is used as a raw material in the process of making cake and other bakery products.
• Work-in-progress: Work-in-progress are those items which are partially finished and are in the process of making finished goods and aids products to be sold in the market. The best example for work-in-process is construction works.
• Finished goods: The name itself says that product is completely finished and ready for sale in the market. Common examples of finished goods are clothes and vehicles etc.

What is Inventory Valuation?

Inventory valuation method is an accounting practice that is followed by each and every business to find out the monetary value of the remaining inventory or the unsold inventory that is in the warehouse. Inventory is one of the important or big assets for any business, so at the time of preparation of a financial statement, it is needed to find out the financial value of the unsold inventory because the value of unsold inventory has to be recorded in the balance sheet.

Objective of Inventory Valuation

The two most common objective of accounting inventory valuation are as:

• Help in determining the Gross Profit - Gross profit means excess of sales over cost of goods sold. As inventory plays a vital role while calculating the value of gross profit. Whereas,

Cost of goods sold = opening stock +purchases – closing stock.

From the above formula, it may be concluded that the value of inventory influences the stock and thereby affects the gross profit.

For example – under valuation of closing stock, it will increase the cost and decrease the current profit and increase profit of subsequent years and vice versa.

• Determining the financial position – Inventory plays a vital role in the ascertainment of the financial position of a business. Closing stock of a company is shown in the asset side of the balance sheet as under head current asset. So, any under and over valuation of inventory will not give a true picture about the overall financial position of the company.

Types of Inventory Valuation Method

There are three accounting inventory valuation methods are used by the company to evaluate the inventory:

• First in First out (FIFO): In FIFO, it is assumed that the item is sold in the order the item came in the warehouse. The items that are purchased  should leave the warehouse first.
• Last in First out (LIFO): In LIFO, it is assumed that the items that entered the warehouse last should leave the warehouse first.
• Weighted-average Cost (WAC): under weighted average, inventory is based on the average price of the item . The average cost per unit is calculated by dividing the total cost by the number of units purchased during the year.

 Which Inventory Valuation Method is Best for Business?

Actually, there is no exact answer to this question. Your inventory valuation depends upon many factors like on the market conditions or on the financial goals for your organization. Here are a few scenarios which can help you to pin down the best inventory valuation technique for your business.

• If the business applies for a loan for expansion purposes: If the business is planning to apply for a loan for the expansion of the business, then the business needs to keep the stock as collateral. In such cases, it is preferable if the value of your stock is high, because higher valuation will give more assurance to the lender. If prices are increasing throughout the year, a FIFO inventory valuation technique will give you a higher value for closing inventory. If prices are decreasing, a LIFO technique will give you a higher value. The value of the closing inventory in your balance sheet is one of the factors used by financial institutions before approving a loan to a company, so the technique that gives you the highest inventory value will be the best for your company.

•  If used for attracting customers: A company with a high profit margin can get a lot of attention from investors and keep its existing shareholders happy. So if you’re looking for a new funding opportunity or if you want to keep happy shareholders with good earnings, then FIFO valuation will be beneficial under inflationary market conditions. Similarly, the LIFO valuation will be a better choice when prices are falling.
•  If looking to save taxes: As every business wants to save money on tax or want to pay less tax , then your inventory valuation technique will help the business in saving tax . Assuming an inflationary situation again, a LIFO valuation technique will save you some money.

Context and Applications  

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

• B.B.A in Accounts
• M.B.A in Accounts