If you operate a manufacturing or retail business, it's likely that you hold some inventory that you have yet to finish or sell. This inventory is an asset to your business as it has value, and will convert to cash at some point in the future. There are several methods for valuing inventory. Each method has a different impact on your tax bill and will determine how healthy your business looks to purchasers, lenders and investors.
Inventory is all the goods you hold ready for sale, which retailers refer to as merchandise, and the raw materials used to manufacture goods. Raw materials are unprocessed materials used to produce goods such as flour for bakeries and aluminum and steel for the manufacture of cars. It also includes partially finished and goods in production or work-in-progress goods as these items will become finished items available for resale. Inventory is the key to your revenue generation. As such, it is classified as a current asset on the company's balance sheet. When you sell an item of inventory, the cost transfers to the cost of goods sold category on the income statement.
Inventory value is the total cost of your inventory calculated at the end of each accounting period. It isn't a cut-and-dried calculation, however, as you can value your inventory in different ways. The rule of thumb is that your balance sheet entry should reflect the "value" of the items to your business.
In certain industries such as bulk-goods retail and manufacturing, the value might be what you paid for the items. For example, you may need 30 screws to build a piece of furniture. It doesn't matter what you paid for those screws as price swings on screws don't affect your end product. Your screw inventory value is the amount you paid.
The situation would be different in, say, a retail electronics business. Suppose your business buys and sells smartphones and you bought your current smartphone merchandise wholesale at $300 per item. If the manufacturer reduces the wholesale price to $250, then clearly your unsold inventory is no longer worth $300. Competitors can now buy and sell the same product cheaper and, all things being equal, you will have to cut your retail price or be undercut by competitors. Reporting the smartphones at cost would overstate your inventory value. The conservative approach here would be to value your inventory at the lower of cost and the current market value.
How you value inventory on your balance sheet determines your ending inventory, which in turn determines the cost of goods sold and therefore profit. Here's the formula for calculating the cost of goods sold:
(Beginning inventory) + (inventory purchases) - (ending inventory) = Cost of goods sold
As you can see, the higher the ending inventory, the lower the costs of sales. This results in higher profits (revenue less cost of goods sold equals gross profit). Conversely, a lower inventory valuation results in higher cost of sales and lower profits.
Besides the impact on your financial statements, there are other reasons why you would need to know your company's inventory value:
Management Decision Making
Holding a high amount of inventory for a long time is not usually advantageous as you will incur storage costs and you risk spoilage and obsolescence. Conversely, holding too little inventory means you won't be able to fulfill customer demand promptly. Keeping your inventory in a tight valuation window allows you to hit the sweet spot in the amount of inventory you hold. By tracking inventory value, managers can also see how current operations stack up against current and historic prices. This can help to support decision making around retail pricing.
Business Sales and Purchases
If you are considering whether to sell your business, the purchase price should include an amount for your inventory on hand. It is in your best interest to value the inventory as high as possible to achieve the best possible selling price. Conversely, when buying a business, you will have to compensate the owner for unsold inventory in the target business. Now, it is in your best interest to value the inventory as low as possible. A sensible approach is to run calculations using the various valuation methods and use the highest/lowest valuations as a jumping-off point for price negotiations.
Collateral for Lenders
Inventory can often be used as collateral for a loan and surrendered to the lender if the business is unable to pay the loan. The inventory valuation will determine how much you can borrow. Your objective here is to show the highest possible inventory value. You can expect to borrow only a percentage of that value.
The Internal Revenue Service lets you deduct inventory costs on your income tax return. You can choose to specify the exact cost (what you paid for the items) or the lower of cost and market value. There are various methods for determining "cost," and each method can yield a different valuation figure. This, in turn, affects the amount you can deduct for tax purposes.
The most precise valuation method is to identify specific items in your inventory and add up the purchase cost of each item. This is impractical for obvious reasons, especially for manufacturing businesses and those that turn over a lot of goods. If you cannot specifically identify the cost of your inventory, you must use either the FIFO, LIFO or weighted average valuation methods.
FIFO: First In, First Out
The FIFO method assumes that you use up your oldest items of inventory first. It's a useful valuation method when inventory consists of many identical items, so you don't need to track each item individually: for example, you have 10,000 identical T-shirts and 10,000 custom-printed T-shirts. With FIFO, you figure out your costs of sales – what you already sold – by reference to the items you purchased the earliest. Inventory is valued by reference to the newest items which are the most recently bought.
Here's an example. Suppose Acme Inc. bought 100 items in April at $1, 100 more in July at $2 and 100 more in October at $3. It sold 150 items during the year. Acme's cost of goods sold would be $200 – the first 100 items at $1 each ($100) and the next 50 items at $2 ($100). Its remaining inventory, comprising the 150 unsold items, would be valued at $400 under FIFO: (50 x $2) + (100 x $3) = $400.
LIFO: Last In, First Out
LIFO is the opposite of FIFO. Here, you determine the cost of sales by the cost of your newest items. This means your inventory is comprised of the cost of the items you purchased the earliest. If Acme used LIFO instead of FIFO, its remaining inventory would be based on the first 150 items it bought for a value of $200: (100 x $1) + (50 x $2) = $200. The cost of goods sold would now be significantly higher at $400. This comprises the last 100 items it bought that cost $3 each ($300 total) and the 50 before that which cost $2 each ($100 total).
WAC: Weighted Average Cost
The average cost method uses the average cost of the items purchased during the accounting period and assigns it to all the unsold inventory and the goods sold. Under WAC, Acme's average purchase price is $2. The cost of the 150 goods sold is $300 (150 x $2). The inventory value is $300 (150 x $2). The main advantage of WAC is that it smoothes out price fluctuations. However, you can only use it internally. The IRS does not let you use WAC for valuing inventory on your tax returns.
To see how FIFO, LIFO and WAC might play out, consider the following scenario. Company ABC purchases 10,000 widgets this year. It sells 7,600 widgets which means it has 2,400 widgets left as unsold inventory at the end of the year.
ABC makes the purchases on the following dates:
- January: 3,000 widgets at $1.00 per widget (total cost $3,000)
- April: 3,000 widgets at $1.25 per widget (total cost $3,750)
- July: 4,000 widgets at $1.10 per widget (total cost $4,400)
- Total purchase price: $11,150
It sells 7,600 widgets on the following dates:
- February: 3,800 widgets at $2.00 (total price $7,600)
- August: 3,800 widgets at $1.80 (total price $6,840)
- Total sales: $14,440
Here's a reminder of the formula for cost of goods sold:
(Beginning inventory) + (inventory purchases) - (ending inventory) = cost of goods sold.
Under FIFO, the inventory is valued at $2,640 (2,400 at $1.10). Cost of goods sold (assuming no beginning inventory) is $8,510 ($0 + $11,150 - $2,640) and gross profit comes to $5,930 ($14,440 - $8,510).
Under LIFO, inventory is now valued at $2,400 (2,400 x $1.00). Cost of goods sold would be $8,750 ($0 + $11,150 - $2,400) which reduces the gross profit to $5,690 ($14,440 - $5,750).
Under WAC, the average cost per widget is $1.115 ($11,150/10,000). Inventory would be valued at $2,676 (2,400 x $1.115) and the cost of goods sold would be $8,474 (7,600 x $1.115). This gives the highest gross profit of $5,966.
To assess the relative value of FIFO versus LIFO, you need to look at whether your inventory costs are going up or down.
- When costs are rising, choose LIFO for greater tax deductions. In a rising-cost environment, LIFO provides a larger cost deduction from your taxes because the most expensive items (the ones you made or purchased last) are factored into the cost of goods sold. This results in higher costs and lower profits. FIFO, by contrast, would give the highest inventory valuation and gross profit.
- LIFO gives the highest inventory valuation and gross profit when costs are falling.
- FIFO generally gives the most accurate cost. That's because it references the most recently purchased items, which means your inventory value should closely match current prices. FIFO is the standard valuation method for most companies for this reason.
- WAC gives a valuation that more closely resembles FIFO. Few businesses use WAC, however, as it isn't accepted by the tax authorities.
The key point here is that you are free to choose whatever valuation method you like and it's permissible to use one method on your tax return and another on the financial statements prepared for managers and investors. As always, you must identify the method you used on your financial statements. Investors will want to see an explanation should you change the valuation method from one year to the next.
What you cannot do, is flip between LIFO and FIFO on your tax returns to get the largest deduction each year. As far as the IRS is concerned, you must use the same valuation method each year.