If a business's biggest asset is typically its inventory, why do small to mid-size businesses often place little emphasis on inventory valuation? With inventory being so significant, it’s crucial to have a clear picture of that inventory for true financial statements and sound decision-making.
Inventory valuation methods exist to capture the costs of purchasing, managing, and distributing inventory. Because daily variances in managing inventory in high and low volume, value, and complexity exist, you should choose a method based on your business environment.
According to generally accepted accounting principles (GAAP), there are several methods of acceptable inventory valuation. The method you choose can substantially affect profitability, taxes, and strategic planning, so clearly understanding your inventory valuation options will allow you to make the correct choice from the get-go.
Acceptable inventory valuation methods include:
Specific-identification is the tracking of a specific cost to a specific piece of inventory from beginning to end in the system. Each piece of inventory is marked with a cost as it enters the system, and that cost remains in inventory until that piece of inventory is relieved. While this method seems simple, it’s not necessarily easy to use – it requires detailed tracking using serial numbers, lot numbers, or project codes. Because of the high level of detail, this method is typically only recommended for low-volume, high-value businesses that experience high volatility in inventory costs.
FIFO (First-In First-Out)
FIFO tracks inventory value by layers. Think of your inventory as a stack of blocks with different costs assigned to them. Each time you add inventory, you place it on top of the stack. Each time you pull inventory, you pull it from the bottom of the stack. That means your oldest inventory item’s cost is determined when inventory is pulled. The FIFO method often weighs more heavily toward your balance sheet when costs are trending upward, as your inventory will carry more value than the inventory you sell. The FIFO method is also a useful tool in accounting for obsolescence.
LIFO (Last-In First-Out)
LIFO is the opposite of FIFO. Again, consider your inventory as a stack of blocks. With LIFO, you would add inventory to the top of the stack and pull it from the top of the stack, making your oldest inventory item’s cost the last one chosen when inventory is pulled. The LIFO method weighs more heavily toward the income statement when costs are trending upward, as you’ll be getting the most recent value of inventory as you relieve inventory. LIFO cannot be used for tax purposes in Canada.
Keep in mind that FIFO and LIFO don’t correspond to specific pieces of inventory, which means the question, “What is one block worth?” becomes difficult to answer. In addition, volatility in costs can cause delayed volatility to your financial statements, which can create misleading results and affect strategic decision-making.
FEFO (First-Expired First-Out)
FEFO, commonly used in the food and pharmacy industries, stipulates that expiring inventory should be sold first. The issue is that FEFO doesn’t consider the price of inventory and the dates it was purchased, so the cost of goods sold and balance inventory can occasionally vary.
Moving Average Cost
Under moving average, which is becoming more common, all inventory for a specific SKU maintains the same cost. Each time inventory is added, the value is added to the total value of inventory, then split evenly across the quantity. This can protect both the income statement and the balance sheet from volatility in inventory costing. It also simplifies reconciliation and reporting on inventory levels and costing.
There’s also the option of performing a manual physical count of inventory. Physical counts can be conducted in cycles, with a little inventory counted each day, or can correspond with the end of a reporting period (a month, quarter, or year). Cycle counting is usually preferred, as waiting until the end of a reporting period becomes a long, tedious process that includes halting warehouse activities. When counting small increments every day, the inventory accounting records should be adjusted to report discrepancies, and the reason for each discrepancy should be researched. Detailed procedures and training are developed over time, which will lead to low transaction error rates and accurate inventory records.
Atlantic Data Systems Can Help
If you’d like assistance in optimizing your inventory, Atlantic Data Systems (ADS) can help. ADS partners with small to mid-size businesses throughout Atlantic Canada and Ontario to help them realize the promise of technology with the right software, services, and support.
We’re ready to work with you and your team to ensure a solution that fits your needs and budget. Let’s chat. Contact us here.