Inventory valuation represents the method a company uses to account for goods sold and retained in the general ledger. A few common methods include first in, first out, last in, first out and the weighted average calculation. Companies can typically select which one works best for their accounting inventory system. Each valuation method has benefits for inventory management.
First In, First Out
FIFO requires companies to sell oldest inventory items first. For example, a company purchases inventory goods on March 1 for $10 and again on March 15 for $12, respectively. FIFO requires all goods priced at $10 sell first during a company’s operations. This will result in lower cost of goods sold and higher net income on the income statement. Inventory reported on the balance sheet is higher as cheaper goods sell first.
Last In, First Out
LIFO is the opposite of the FIFO method. Using the example above, goods costing $12 will sell first under the LIFO method. This will result in higher cost of goods sold and lower net income on the company’s income statement. The company’s inventory balance reported on its balance sheet will be lower as the cheaper goods remain in inventory. A significant disadvantage to this valuation method is the potential for spoiled or obsolete inventory as companies retain older inventory goods.
The weighted average method does not track which goods sell first. Companies will simply take the cost for all inventory items — $10 and $12 from the previous example — and average them together. Inventory goods will then sell at a cost of $11 per item. This method is often simple as computerized inventory systems will average inventory automatically if necessary for companies. Weighted average inventory also creates a smoother balance between cost of goods sold and final inventory balance.
Companies may be subject to the lower-of-cost-or-market rule when accounting for inventory. This principle requires companies to reduce inventory items if the market value is different from historical cost. Automotive dealerships often face this issue. For example, holding previous model cars for several years will reduce the value of this inventory. Companies must write off the inventory cost reduction as a loss against net income. This reduces the company’s inventory asset value and net income for an accounting period.