With inventory being one of the biggest assets your company has, knowing the basics of valuation and identifying which accounting method to use is a must. Depending on the size and scope of your business, you may also find a couple of quick ways to do a stock valuation or inventory count quite handy.

While there are a number of techniques and methods to choose from, let’s take a look at the three most commonly used and see what benefits they have. While we’re at it, we’ll also take a look at some quick valuation methods that can help you keep on top of your inventory management and accounting. First, some inventory basics.

What counts as inventory?

By inventory we mean any goods, products, items or parts that are to be sold or used in the production of saleable goods. For a lot of businesses, inventory is one of their biggest assets as well as one of their biggest expenses.

What are COGS (Cost of Goods Sold)?

COGS are the direct costs of creating or producing saleable goods. They include the cost of materials, labour and operations but exclude indirect costs like sales, transport and advertising. From an accounting point of view, COGS are treated as expenses, so can be deducted from the company’s revenue. The result is the company’s gross margin.

To give you an example of how to calculate COGS, a nice easy formula to follow is:

Beginning inventory + purchases – ending inventory = cost of goods sold

The three most common valuation techniques

The three most commonly used inventory valuation methods are Last-In-First-Out (LIFO), First-In-First-Out (FIFO) and Average Cost (AVCO).

Both LIFO and FIFO are cost assumption methods. LIFO assumes that the newest stock is sold first and FIFO assumes that the oldest stock is sold first. AVCO is a method that assigns an average cost of production or purchase to each product.

Which is best?

While they all have their benefits, the best method is ultimately the one that works best for your business. To give you an overview, let’s look at some basic observations about these techniques and how they compare.

First-In-First-Out is the more widely used of the cost assumption methods and is generally considered the better option when costs are increasing – like in times of inflation. Because it matches the oldest costs to the most recent sales there tends to be a higher reported profit and a higher tax liability. Also, the FIFO method is usually a more accurate match to the actual flow of goods.

Last-In-First-Out is most popular with companies that want to keep their tax liability low. The opposite of FIFO, LIFO matches the most recent costs to the most recent sales, helping to reduce the possibility of any overstatement of profit.

Also of note, FIFO is the most accepted method globally while LIFO is predominantly used in the US.

Average Cost is a useful method for businesses that are unable to set specific item costs due to product intermingling. It’s also simple to calculate and provides consistency across all products.

Here’s the basic formula for working out average cost:

Average cost per unit = total cost of goods ÷ total units in inventory

Perpetual or Periodic management systems?

Another consideration is whether to use a perpetual or periodic inventory management system. This is an important choice as it dictates how your business accounts for, tracks and manages stock on an ongoing basis. Ideally a management system is a way of automating all the processes of inventory control and management.

Periodic systems require the regular manual counting of your physical stock and don’t necessarily need inventory management software. Whilst this is okay for businesses with a small amount of stock or for those just starting out, it presents difficulties as the need for better and more accurate information increases.

Perpetual systems on the other hand, only require a manual stock count to check for obsolete, missing or damaged stock as they constantly adjust stock levels and accounting layers as sales and purchases are made. As a general rule, perpetual systems require the use of automated inventory management software in order to work effectively.

While it always comes down to what you feel is the best fit for your business, perpetual software systems offer the best all-round solutions and are becoming more and more affordable and easy to use. The best products offer a great range of functions and features as well as useful integration with existing software.

Estimating inventory value

There are two common methods for estimating inventory value – the Retail Method and the Gross Profit Method. These are useful when you’re unable to do a manual count or just want to get a quick idea of your rough inventory value. Let’s take a closer look at the Retail Method and break it down to see how it works.

The Retail Method

This method is handy if you want to work out your inventory’s value by using the retail price of your stock.

Start by working out your retail value ending inventory: Ending inventory = (Retail value beginning inventory + Purchases + Mark-ups – Mark-downs – Sales)

Then work out your cost to retail ratio: (Cost of beginning inventory + Cost of inventory purchases) divided by (Retail price of beginning inventory + Purchases + Mark-ups – Mark-downs)

Now multiply your retail value ending inventory with your cost to retail ratio.

Some other valuation tips and tricks

And here is a simple way to determine inventory value at a pinch: If you’re wanting to do a quick calculation to know what your ending inventory is for any period, here is an easy formula to use:

Beginning inventory + purchases – cost of goods sold = ending inventory

How we can help

With so many choices available, knowing what your business needs in both the short and long term will help you decide what systems and methods are right for you.

If you need help selecting or integration your current inventory system into your current business processes please contact us.
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