Valuation of Inventory: An Overview

Inventory is a critical current asset that impacts corporate performance and profits. It determines the cost of products sold and the worth of unsold products in storage.

In simple words, when an enterprise prepares its financial statements, inventory valuation helps determine the value of unsold goods. The evaluated inventory is included in the financial accounts.

Importance of Inventory Valuation

• Determining the company’s financial status: Inventories are included in the profit and loss statement and the balance sheet. As a result, the valuation must be done correctly to avoid reflecting an improper financial position.
• Calculating gross profit: When combined with direct revenue collected, the cost of goods sold (COGS) will help calculate gross profit. To begin determining gross profit, you must first determine the cost of goods sold. After calculating COGS, it is compared to sales, and the difference is either gross profit or gross loss. The net income calculation is directly affected if the opening or closing stock is overvalued or undervalued. It has a direct impact on net income estimations. As a result, inventory valuation must be reasonable and accurate.
• Analysis of liquidity: Inventory contributes to a large segment of working capital. Since it is a current asset, it should not be retained for an extended period. Inventory is conducted to identify the company’s liquidity levels. The stock turnover ratio, in particular, needs to be high.
• Statutory observance: According to the AS-2 and Ind AS-2 (value of inventories) rules, the company must disclose the following inventory information:

1. Accounting policies are employed in the measurement.
2. Carrying a large number of inventories.
3. Inventory will be recorded as an expense.
4. Inventory write-downs and write-down reversals.

Top Inventory Valuation Methods

• FIFO (First In First Out)

It refers to the principle that the oldest goods in your warehouse should be sold first. For example, if you purchase a stock in January and another in August, you must try to sell the January stock first. Since prices climb over time, the inventory you’re left with is worth more at the current market rate.

Similarly, because it is based on the cost of the previous inventory, the cost of goods sold drops. In the end, you will have greater revenue to report on your balance sheet, which will result in a higher taxable income. FIFO is popular since it is commercial savvy.

• LIFO (Last In First Out)

This method is the opposite of FIFO. Here, you first sell the inventory that arrives last in your company. So, if you bought one stock in February and another in November, you’ll sell the November stock first. It enhances the matching state of your present business costs, but it is not appropriate in most cases. Since the cost of the goods is higher, the gross profits are taxable, and the income is lower.

• Retail Inventory Method

Here, you add up the total retail worth of the items, subtract their total sales and increase the resulting value by the cost-to-retail ratio. This is a popular method in the handicraft industry.

• HIFO (Highest In, First Out)

This method of inventory value is based on the assumption that your most expensive items will be sold first. This means that if you have a higher-priced good and a relatively cheaper good in your inventory at the same time, you will sell the former first. It is also beneficial from a salesperson’s standpoint since corporations prefer to sell their costlier products first.

• LIFO (Lowest In, First Out)

This method is the opposite of HIFO. Here, your lowest-priced items sell first. In this strategy, your cost of goods is lower, but your closing inventory is larger. This may appear to reduce your short-term earnings, but it will ultimately increase your gross profits and taxable income.

• FEFO (First Expired, First Out)

In the case of FEFO, the items that are about to expire are the first to be sold out. This helps avoid business losses. It is commonly used in the food business and disregards the impact of prices and purchase dates. As a result, your total cost of items will differ in this scenario.

• Lower Cost or Market

This method states that you should evaluate your inventory using the lower factor between the original cost and the current market price. This technique is employed when the inventory has been stored for an extended period or has been damaged and become obsolete.

• Weighted Average Cost

It is expected that you will sell all of your items simultaneously. This is used for commodities with identical prices that are indistinguishable over time. As a result, the average price is calculated throughout the period.

Depending on needs, most firms that sell physical products employ FIFO or LIFO. However, whatever approach you use, be sure it aligns with your business goals. Most businesses wind up with damaged goods as a result of poor warehouse operations.

Conclusion

The valuation of inventories helps businesses demonstrate the company’s genuine and fair financial status. Inventory valuation falls under AS- 2 and describes the value of the company’s most essential asset, inventory, which the company holds to produce things for sale in the form of raw materials, work-in-progress, and finished goods.