Inventory value is the monetary amount associated with the goods in inventory at the end of the accounting period. Valuation is based on the costs incurred to acquire the inventory and make it ready for sale. All you need to do to determine the correct inventory value is to use the right inventory method.
Inventory is the largest current business asset. Inventory or stock valuation allows you to evaluate your Cost of Goods Sold (COGS) as well as the profitability of your business. The most widely used valuation methods are FIFO ( FIRST-IN, FIRST-OUT ), LIFO ( LAST-IN, FIRST-OUT) and average.
Table Of Contents
1 What is the Importance of Determining the Correct Inventory Method?
1.1 Determining gross income
1.2 Establishing financial position
2 Kinds of Inventory Method
2.1 FIRST-IN, FIRST-OUT (FIFO)
2.2 LAST-IN, FIRST-OUT (LIFO)
2.3 AVERAGE
3 Which Inventory Method is Best for Your Business?
What is the Importance of Determining the Correct Inventory Method?
Inventory refers to items that are intended to be sold or items that are not sold. In a manufacturing company, it includes raw materials, semi-finished goods and finished goods. Inventory valuation is carried out at the end of each financial year to calculate the cost of goods sold and the cost of unsold inventory.
It is very important to choose the right inventory method because this will determine the calculation of inventory value in your business later.
The simple thing that happens if you choose the wrong method will make it difficult for you to manage inventory availability which will have an impact on excess or shortage of stock affecting production and business profitability.
Other things you get for using the right inventory method in your business are:
Determine gross income
Inventory is used to find a gross profit, which is the excess of sales over the cost of goods sold. To determine gross profit or trading profit, the cost of goods sold is adjusted for the income of the accounting period.
Basic selling price = Initial stock + Purchase – Final stock
The above equation shows that inventory value affects costs and thus affects gross profit. For example, if the ending stock is overvalued, it will increase the profit for the current year and reduce the profit for the following years.
Establish financial position
Closing stock is shown as a current asset. The closing stock value on the Balance Sheet determines the financial position of the business. Overvaluation or undervaluation due to incorrect selection of the inventory method can give a misleading picture of the working capital position and overall financial position.
Inventory Method Type
To use the inventory method depends on how the stock is tracked by the business over time. A business must pay attention to inventory at a cost. Because inventory is constantly being sold and re-stocked and prices are constantly changing, businesses must make optimal cost flow assumptions across inventory.
Here are 3 inventory methods that are widely used by businesses in Indonesia:
FIRST-IN, FIRST-OUT (FIFO)
This method is based on the premise that the first inventory purchased is the first to be sold. The assets remaining in inventory are matched against the most recently purchased or produced assets. According To Saheb Academy FIFO Method (First In First Out) Store Ledger Account- Problem – BCOM / BBA
It is one of the most common inventory valuation methods used by businesses because it is simple and easy to understand. During inflation, the FIFO method results in a higher ending inventory value, a lower cost of goods sold, and a higher gross profit.
The drawback is that the FIFO model is difficult to provide an accurate depiction of costs when there are rapid price increases. Also, unlike the LIFO method, this method does not offer an advantage at the time of tax reporting.
LAST-IN, FIRST-OUT (LIFO)
Next is the LIFO inventory valuation method. The analogy is that the newer inventory is sold first while the older inventory remains in stock. This method is rarely used by businesses because old inventory is rarely sold and gradually loses value. This results in a significant loss to the business. According To Saheb Academy LIFO Method (Last In First Out) Store Ledger Account- Problem – BCOM / BBA
The only reason to use LIFO is when a business expects inventory costs to increase over time and cause price inflation. By moving high-cost inventory to cost of goods sold, the reported profit rate can be lowered. This allows the company to pay less tax.
AVERAGE
Then there is also the average inventory method which is used to determine the amount included in the cost of goods sold and inventory. The calculation of the average cost per unit is calculated as follows:
Average Cost Per Unit = Total Cost of Goods in Stock / Total Units in Inventory
This method is usually used to determine costs for units that are indistinguishable from one another and it is difficult to track individual costs.
Which Inventory Method is Best for Your Business?
Choosing the right inventory method is important because it has a direct impact on the profit margins of the business. Your choices can cause drastic differences in cost of goods sold, net income and ending inventory.
There are advantages and disadvantages to each method. For example, the LIFO method will give you the lowest profit because the last item of inventory purchased is usually the most expensive whereas FIFO will give you the highest return because the first item in stock is usually the cheapest.
To assess which method is best for you, you need to pay attention to changes in inventory costs.
- If inventory costs are increasing or potentially increasing, using the LIFO method may be preferable. Because the goods with higher costs will be prioritized to be sold first, therefore resulting in higher costs and lower profits.
- If your inventory costs are going down, FIFO might be the best option for you.
- For a more accurate cost estimate, use the FIFO inventory valuation method because it assumes the old items that have expired are the first to be sold.