Inventory Valuation Methods: The Best Tool for Checking Inventory
Counting your inventory at the end of a period is no fun task, especially when there are several ways you can calculate how much you’ve sold and how many items are going to be carried over into the next period.
No one wants to do it, and there’s no enjoyment in it, but as a Navy Seal once said in an inspirational YouTube video, you got to “Make your bed.”
That’s why we’ve investigated the different types of inventory valuation methods your business can use when checking in on your stock levels.
But why are inventory valuations important?
Production costs change over time due to inflation or bottlenecks in your workshop, so these methods allow you to work out the actual value of your products.
But, as we look into what is the purpose of inventory valuation methods, we’re going to give you the secret to, regardless of which one you decide to use, optimizing them for your business.
So, in this article, we’re going to look at what are inventory valuation methods, some of the inventory valuation methods examples, and the best tool for making them work.
What Are Inventory Valuation Methods?
Inventory valuation methods are an important inventory management practice of applying a monetary value to a manufacturer's products, that make up their inventory at the end of a reporting period.
The idea is that the costs to produce products change over time and performing one of the many inventory valuation methods allows you to allocate costs correctly to your sales and your remaining inventory.
So, when looking at what is the purpose of inventory valuation methods, you need to understand how is inventory valuation calculated.
And the key aspect of the inventory methods is calculating your cost of goods sold (COGS) - which appears as a current asset on a balance sheet - and your current inventory levels at the end of a reporting period - as an expense.
Regardless of which inventory methods you decide to use, it doesn’t include the administrative or selling costs of inventory.
However, the costs that are associated with inventory valuation methods are:
So, you know what is the purpose of inventory valuation methods, but now comes the difficult part, actually choosing a method!
Let’s look at each tactic, their inventory valuation methods examples, along with their advantages and disadvantages.
The First-in-First-Out Method (FIFO)
First in, first out is probably one of the most utilized inventory valuation methods used by modern product-making businesses, especially ones that handle perishable goods.
When practicing FIFO, a business is aiming to sell the products they manufactured in the order they were created.
To simplify the process, your oldest products in stock are the first to be sold.
Tracking the finances of FIFO means that you simply charge the older inventory to the cost of goods sold (COGS) as soon as it’s sold and calculate the remaining costs of inventory left on the shelf at the end of a reporting period.
An Example of FIFO
There’s an entrepreneur who makes t-shirts with some post-modern slogan which they believe is going to sell like hotcakes.
The maker manufactures 100 t-shirts that cost $10 to produce.
At the end of the month, the trendy designer managed to sell 34 shirts.
Using FIFO, the calculation would look like this:
COGS = (34 t-shirts x $10 FIFO cost) = $340
Then the business will need to calculate the cost of inventory that wasn’t sold and is carried over to next month:
Remaining Inventory Value = (66 shirts x $10 cost to make) = $660
Advantages and Disadvantages of Using FIFO
The four distinct advantages to using inventory valuation methods such as FIFO is:
— It’s very easy to apply;
— The flow of costs corresponds with the actual physical flow of goods;
— It eliminates the chance to manipulate income; and
— The balance sheet is more likely to approximate the current market value.
FIFO removes the cost from the oldest units in inventory as soon as the company sells them.
These advantages experienced from using FIFO to manage inventory means any products produced toward the end of a period don’t affect the COGS or net income.
However, a disadvantage to using FIFO includes the recognition of paper profits, and a bigger tax burden if used for tax purposes in a period of inflation.
Last-in-Fast-Out (The LIFO Method)
Last in, last out is another of the inventory valuation methods, which is the complete opposite of FIFO. When using the LIFO method, the newest inventory is sold first, with the older inventory sticking around on your shelves.
So, as the costs of manufacturing increase, the COGS in the LIFO inventory method assumes that the cost of the latest units purchased are higher, and the ending inventory balance is lower.
But, before we move on, FIFO vs LIFO, a rule of thumb is that if you’re going to practice one of these inventory valuation methods, FIFO is perfect for those who have a short expiry date on their products and inventory with a long life is better suited for LIFO.
An Example of the LIFO Method
Let's use the above genius entrepreneur who repurposes memes by printing them on t-shirts for financial gain.
Using the same example, but instead, the t-shirt maker has decided to use the LIFO method.
100 t-shirts are produced at $10. But this time, the entrepreneur produces another 100 t-shirts. However, the second batch costs $12 to produce due to inflation.
The same as before, the t-shirt maker is only able to sell 34 t-shirts.
The formula for the LIFO method would look something like this:
COGS = (34 shirts x $12 LIFO cost) = $408
The maker still has 166 shirts in stock, 100 shirts at $10 and 66 shirts at $12.
This would mean:
Remaining Inventory Value = (100 shirts at $10) + (66 shirts at $12) = $1,792
Advantages and Disadvantages of Using the LIFO Method
You might be wondering why someone would use this method of inventory valuation, but the biggest advantage to using LIFO, especially during periods of inflation, is that the newest costs charged to COGS are also the highest costs.
Companies who like to use the LIFO method believe it leads to a better matching of costs and revenues. This is because the income statement reports both the sales revenue and COGS in the current value of the selling price.
LIFO’s gross margin is a better indicator to generate income than the gross margin calculated using FIFO.
However, the disadvantages of using the LIFO method is that if you’re a manufacturer who handles perishable goods, then this method isn’t going to be viable.
Moving Average Inventory Costs (MAC) Inventory Valuation
Moving average inventory costs is a costing method used under the perpetual inventory system.
When using MAC, you essentially work out the costs of your inventory in real-time. So, when you finish production on an item or purchase more material, the value of the new order is added to the value of your inventory, then divided by your current inventory levels.
MAC might sound complicated at first glance.
However, comparing it to FIFO vs LIFO, the difference in using WAC instead of those is that your inventory and COGS are based on the average cost of all your items based on fulfilling orders.
An Example of Moving Average Inventory Costs
For old times’ sake, let’s once again use the example of the t-shirt maker and their final inventory level when finishing the two batches during one period.
Instead this time, the t-shirt maker has sold 34 shirts from their first batch of 100 (valued at $10) and just finished their second batch (which cost $12).
Once you have your new inventory levels, you use your new total stock value, and divide it by the total amount of inventory, to get the total average cost of your inventory.
So, using the MAC method the theory will look something like this:
COGS = (66 t-shirts at $10) + (100 t-shirts at $12) ÷ 166 t-shirts = $11.20
Advantages and Disadvantages of Using MAC
The biggest advantage of using MAC is that it’s an incredibly simple way to track inventory expenses compared to other inventory costing methods.
You can store inventory regardless of which batch it belongs to. Once you’ve taken units out of inventory, you don’t need to track their original costs before pricing them.
Using MAC, you simply mark up the average price of the units, making picking and pricing you inventory hassle-free.
However, an issue of using inventory valuation methods, like moving average inventory cost is that it assumes that your products are identical, which for the most part is not the case.
To use MAC appropriately, you will need to track the average costs of your entire inventory and the different types of tools you use.
PRO TIP: Which of the following inventory valuation methods should be used for unique items? It all depends on your item's expiry date! But, once you figured out your products life expectancy, be sure to use an excel template for manufacturing company to keep on top of inventory.
What Is the Best Inventory Valuation Method?
After all this in-depth analysis of these inventory valuation methods, you’re probably scratching your head and wondering which is the best for your business.
And we have the answer!
Are you sat down? Get ready, the answer is... it depends.
MAC is the middle-ground approach for a lot of companies looking to implement one of the inventory valuation methods.
Though, for a lot of manufacturers, it boils down to one of the two inventory costing methods, FIFO vs LIFO.
But the thing is, outside of regulations, when picking between FIFO vs LIFO it all depends on the type of products you manufacture.
If your company handles things such as auto parts, farm equipment, construction equipment, alcohol, hardware, apparel, furniture, basically any products that can hang around on your shelf, then the LIFO method is a good way of valuing your current assets.
But, you should also take into consideration that your inventory costs are likely to increase because your higher cost items are sold first, meaning some items could become stuck in your warehouse’s inventory.
If your business handles any perishable goods (foodstuffs), anything with a short expiry date, or products that can quickly become archaic inventories, then FIFO is the way to go.
However, with FIFO, you’re more likely to get an accurate cost because it assumes your older less-costly items are sold first.
Though there are regulations that you need to follow depending on your trade, and you’ll need to check before implementing one of the inventory costing methods. For example, if you’re able to use the LIFO method in your business.
Make sure your financial reporting standards allows you to practice whichever inventory valuation method you intend to use.
But, to quickly summarize: MAC is the safest approach and FIFO vs LIFO all depends on your inventory.
Either way, once you know which one you’re going to rock and roll with, you’re going to need to find a tool which can help you keep your inventory under control.
Smart Manufacturing Software for Inventory Costing Methods
Regardless of which one of the inventory valuation methods, FIFO vs LIFO or take the middle ground with MAC, finding the right tool which can help you track and monitor your inventory levels is the key to making it work.
Otherwise, you’re going to be stuck counting your inventory by sight and probably using inefficient Excel spreadsheets to make your calculations from the inventory costing methods.
Katana’s smart manufacturing software has been designed by manufacturers, for scaling manufacturers.
Katana uses the MAC method and has been built to aid any maker regardless of their manufacturing processes.
This allows you to get the most current valuation on your inventory levels for each product type, perfect for manufacturers looking to track more the one item that they sell.
Check out this informative video on how Katana helps you automatically track your costs of materials and products with ease.
But how does Katana help manufacturers get more control over their inventory valuation methods?
The software helps you with its:
1. Smart Auto-Booking Engine
Katana’s unique auto-booking engine autonomously monitors your inventory movements in real-time, meaning your available raw materials and finished goods are automatically allocated to open orders as soon as they’re generated.
On top of this, Katana gives you a breakdown of manufacturing costs, COGS, and the value of remaining products in stock to help you understand your inventory levels at the end of a reporting period.
2. Visual and Modern Interface
The software’s simple and elegant dashboard helps you easily navigate your entire business, from selling to manufacturing, to get an overview of your company from one centralized point.
If you’re using QuickBooks for performing your inventory costing methods, then have no fear! Katana can integrate with your QuickBooks Online and synchronize your inventory levels, so you can run your business from Katana, and push your receipts and invoices to QuickBooks for tracking finances.
And there you have it, all you need to know about inventory valuation methods. Just remember to stick to these three questions when deciding to implement one of the systems:
1. Do your products have a long enough shelf life to be supported by the system you choose;
2. Does your financial reporting standards allow you to practice the method; and
3. Do you have a tool in place which can help you pull off any of the inventory costing methods?
This mini-check list is a good signpost to follow on the road to exceptional inventory management practices.
But if you want to hit the highway at the fastest speed possible, make sure you get set-up with a smart manufacturing software which can handle all your business’s needs.
Why not take Katana out for a test drive? We offer a 14-day free trial, so you can experience the power of automation firsthand and learn for yourself why Katana is perfect for your business when getting more control over your inventory valuation methods.
If you have any questions, please feel free to get in touch, and we’ll be more than happy to answer them.
Until next time, happy manufacturing.