You must know the value of your business inventory, but how do you determine what your inventory is worth? You can use the cost method or the market method, but both have advantages and disadvantages. You need to know which one will work best for you, so you can manage your inventory costs. Learn the ins and outs of inventory valuation, and you will add one more management tool to your skill set.
Cost Method of Valuing Inventory
Using cost to value inventory makes sense to most businesspeople, which may be why it is the most-used method. Simply multiply the number of items by how much they cost you per unit. Once you do this for all items you carry, you know exactly how much cash you have tied up in inventory.
Disadvantages of the Cost Method of Valuing Inventory
When using the cost method, watch out for the disadvantages: damaged goods may have less value than what you paid for them, changes in market prices may have lowered the value of your inventory below cost and some items may be obsolete. The cost method of valuing inventory may mislead you into thinking you have more value in your business than you really do.
The Market Method for Valuing Inventory
The market method assigns a value to your inventory based on what you could get in the market place at the time inventory is counted. This allows you to discount damaged goods, write off obsolete products and adjust your valuation based on the fluctuation of market prices.
Disadvantages of the Market Method for Valuing Inventory
The market method sounds good in theory, but in practice market prices can be hard to determine. In addition, some items will have risen in value since they were purchased, and this will raise your inventory numbers. Damaged items may require too much guesswork to value them. This method clearly requires the most work, meaning a manager will have to oversee the process, especially when it comes to assigning values to items. This can increase the cost of taking inventory.
Disadvantages of Using the Lower of Cost or Market Methods
The choice sounds simple, but in practice, you essentially have to value your inventory twice. This costs money, since you have to pay management to do twice the work. Also, using market value because it is lower still does not tell you how much cash you have tied up in inventory. Using cash value because it is lower does not tell you how much your inventory could bring in current market conditions. Finally, if you are selling your business, you could make the argument that you actually want the higher value to make your business worth more.