Inventory refers to any goods purchased with the intention of selling them back to customers at a profit. Accurate valuation of inventory is crucial in order to calculate your cost of goods sold, which ultimately affects your income statement.
There are four primary methods of inventory valuation: FIFO, LIFO, Weighted Average and Specific Identification. Each has their own benefits and drawbacks.
FIFO (first-in, first-out) inventory accounting method is one of the most popular approaches for inventory. It’s often more accurate and corresponds with actual flow of goods into and out of fulfillment warehouses; furthermore, this is also ideal for businesses that face fluctuating price inflation as it provides a clearer picture of costs than using inflation adjustments alone.
Utilizing FIFO, you record the cost of initial inventory when it arrives and allocate this cost across each batch as it is manufactured. At the end of an accounting period, sales made to customers are deducted from your starting inventory level to calculate an ending inventory value based on when its first item sold occurred.
Your accounting inventory method has far-reaching ramifications on both net income and balance sheet performance. There are various options available to you for selecting an inventory method; international standards do not permit LIFO; most companies are opting out of LIFO use while some still utilize LIFO for inventory management but switch over to FIFO for tax reasons.
Last-in, first-out inventory valuation method helps reduce tax liability by using your latest cost of goods sold as the basis for calculating your taxable income. This approach can be particularly helpful to businesses dealing with perishable goods that become outdated quickly such as technology products.
However, LIFO accounting also comes with its share of drawbacks. Depending on your industry and market conditions, LIFO could lead to spoilage or waste; additionally, this method requires businesses to keep detailed records on costs and inventory transactions which could strain resources and become time-consuming tasks.
Companies typically opt for the first-in, first-out (FIFO) inventory valuation method for its many advantages. When making this choice, however, it’s essential that companies fully comprehend its repercussions as choosing this approach will have an effect on your company’s taxable income and net profit figures as well as needing IRS approval should any change take place; CPAs can help guide businesses through this process.
Weighted average inventory valuation allows for more consistent valuation during falling and rising price environments, and businesses should carefully evaluate operational realities, income needs and tax considerations before selecting their inventory valuation method of choice.
This method also simplifies calculations and record keeping by constantly calculating an average cost rather than once every period. This approach can be especially helpful when inventory costs are indistinguishable or highly variable and difficult to track separately.
Price volatility can make this method inaccuracy vulnerable; software solutions exist that automatically calculate this method once configured to your inventory and products/materials, along with additional features like tracking inventory, financial reports generation and more – Craftybase offers this feature with its perpetual inventory weighted average cost method that automatically recalculates whenever new inventory enters or leaves the system.
The specific identification method of inventory valuation works effectively for companies that possess unique or high-value products, providing precise tracking of each item’s cost as an accurate reflection of a business’s cost of goods sold. For instance, retailers selling distinctive goods like fine art or tailored clothing could find this approach particularly advantageous as it reduces write-down risks due to obsolescence or theft while helping decrease expenses by accurately valuating each product at its true market value.
An inventory management solution simplifies calculations of ending inventory by allocating annual expenses directly against unsold items. A vintage car dealership could use this approach to track each of its 50 cars in relation to original purchase cost and sales price for accurate insights on popular models and features. Investors who wish to reduce tax capital gains through matching stock sales with acquisition costs could use this strategy as well. Unfortunately, large organizations find implementation difficult since each item needs its own unique identifier in order to use this technique effectively.