COGS (Cost of Goods Sold) is the overall cost of producing and selling a company’s product. It may seem like calculating this cost should be very straightforward, but it can actually be very difficult, considering how the values of products are almost constantly in flux.
What Is Inventory Valuation?
Inventory valuation, in short, is a record of a company’s product value. In addition to the total cost of the company’s current inventory value, inventory valuation also takes into account purchases made from suppliers and products sold in a given reporting period. This process can be complicated by the shifting value of goods, as well as other factors like the longevity of product. In order to handle the changing cost of goods, there are a number of costing methods that companies can use for inventory valuation.
Last In, First Out (LIFO)
LIFO is one method for determining the value or cost of your inventory, and it is only used in the United States. It assumes that the last product in is the first product to be sold. In other words, the company’s newest products are the first to be sold.
To illustrate this concept, imagine a convenience store orders 100 candy bars at one dollar each. A week later, they make another order of 100 candy bars, but the cost of each candy bar has risen to two dollars. If the convenience store then sold 100 candy bars, the value of the remaining inventory would be $100, using the LIFO method. This is because the store would be assuming that the last products to come in, were also the first to go out. Therefore, the two-dollar candy bars were the first to go, according to the inventory.
First In, First Out (FIFO)
FIFO is essentially the inverse of the LIFO costing method. It assumes that the first product in is the first product to be sold. In other words, the company’s oldest products are the first to be sold.
Using the candy bar example above, the value of the remaining inventory would be accounted as $200 rather than $100, per the FIFO method. This is because the business would be assuming that the first one hundred candy bars, which cost $100, were the first to be sold.
Weighted Average Cost (WAC)
WAC is perhaps the most intuitive and simple inventory valuation method. Using this method, a company simply determines the average cost of their inventory orders. However, while potentially simpler, WAC does not always accurately reflect the value of inventory, depending on the business model and product volume.
Returning to our convenience store example, the average cost of all candy bars in stock would be $1.50. Therefore, using the WAC method, the remaining 100 candy bars would be valued at $150. In the case of similar products at similar price points at a time of relatively stagnant pricing, the WAC method can be relatively reliable. However, it can become far less so if the cost of different items and/or different orders varies widely.
Which Inventory Valuation Method Should You Use?
Choosing the appropriate inventory valuation method for your business will depend on a variety of factors such as your business model, your product type and volume, and any applicable accounting laws.
The LIFO method is actually not legal for reporting in most countries, due to International Financial Reporting Standards. However, LIFO is permissible in the United States, per generally accepted accounting principles (GAAP). LIFO is rarely used; often the only benefit is the potential to lower the tax bracket of a large business by underestimating the value of the stock when prices are rising.
The FIFO method is commonly used, due to its accurate reflection of the ending value of inventory and its compliance with most inventory reporting laws and guidelines. It is especially useful for businesses with highly perishable inventory, like an ice cream company, in which case the oldest products need to be sold first.
The WAC method is ideal for inventory that is difficult to record individual costs for. This could be the case for many reasons, such as a very large inventory, or a recording system that is not capable of efficiently recording that information.
Regardless of the method used to record inventory, doing so by hand is a tedious, unnecessary, and sometimes a near-impossible exercise. An integrated, digital inventory management solution will help vastly improve efficiency, as well as expand reporting options. Because valuation methods like WAC are often only necessary because of difficulty keeping track of general inventory and/or specific orders, a sophisticated inventory tracking program can give a business more freedom to decide on an inventory valuation method based on other merits. Improved inventory-monitoring capabilities can diminish waste by tracking finished goods, catalog order pricing and arrival time, and allow a business to choose a costing method that may be more beneficial from a taxation perspective.