Managing inventory is an important part of running a successful retail business. To maximize income, companies need to have the right amount of products at any given time. As a company purchases inventory, the company will typically incur varied costs as the price charged by suppliers of the inventory fluctuates. Inventory valuation methods help businesses to recognize the cost of inventory for accounting purposes.
Retail Methods of Inventory
Last-in-first-out (LIFO) and first-in-first-out (FIFO) are the two most commonly used inventory valuation methods. LIFO assumes that each unit sold was the last inventory unit purchased. FIFO, on the other hand, assumes that the last unit sold was the oldest unit in inventory. In a period of rising prices, a business that uses FIFO will have lower costs and higher income than a business that uses LIFO. Neither of these techniques considers the stock of inventory the actual item came from.
Dollar Value LIFO
Dollar value LIFO is an inventory technique computed in dollars. This inventory technique lists each batch of items by dollar value instead of inventory units. This leads to a much simpler accounting, as different products with the same value belong to the same grouping or pool. Many retailers use the dollar value LIFO method because as prices go up over time, this inventory technique reduces tax liability for the business. This tax reduction results from the fact that the last inventory units purchased by the business were the most expensive. This, in turn, reduces the company’s taxable income.
The basic techniques of inventory valuation do not take into consideration inflation. However, to make an accurate valuation a business needs to take make adjustments for inflation. The dollar value method uses a price index to adjust the value of inventory every year. This also the company to determine if the inventory prices genuinely increase or simply increase because of inflation. Internal Revenue Service tax rules also permit companies to use a simplified dollar value LIFO if the business operates with relatively high gross margin percentages.
Double-Extension Dollar Value LIFO Method
The double-extension method is a procedure that a business can use to calculate the dollar value LIFO in a situation where broad inventory groupings of similar items are not available. To obtain the index using this method, the business uses a representative portion of items in inventory. The basic problem with the double extension dollar value LIFO method is that this method requires an accountant to deal with items not present in the base year inventory and find adequate comparable products. Adopting a link chain method can help to solve this problem but can prove costly. A certified public accountant can advise businesses on the inventory valuation method most beneficial to the specific business model.
Brian Bass has written about accountancy-related topics and accounting trends for "Account Today." He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Bass hold a master's degree in accounting from the University of Utah.