If you don’t know what you’ve got, you don’t know what you can make. While simple, this statement sums up the importance of inventory accounting in any business. But the value of inventory is just as significant. While accurate unit counts mean actual performance will match the production schedule, inventory valuation affects many areas within the company.
Inventory valuation represents a company’s invested cash in inventory required to produce or sell goods. It’s used at the end of an accounting period, representing the value of the material and the costs associated with the acquisition, storage, and handling of the material.
Inventory valuation allows companies to calculate and analyze their Cost of Goods Sold (COGS). This valuation, in turn, is used with other enterprise-wide variables to determine overall profitability. Without an accurate inventory valuation, companies may lose money or miss opportunities for increased profits.
Inventory valuation is important because it impacts several critical areas in any company. These areas include:
Inventory is usually the highest cost for manufacturers. With correct inventory valuation, companies can calculate an accurate COGS. COGS represents the beginning inventory value plus the cost of all purchases and associated costs, minus the inventory value at the end of the accounting period.
Inventories are usually taken at quarter-end accounting periods. If the end value in one period is incorrect, the beginning value of the next is off as well. If the inventory counting system is prone to such errors, this can impact entire year profits and affect profitability.
Many manufacturing companies utilize “bridge loans” or “factoring.” Factoring is a short-term loan strategy to provide cash flow between long-term accounts receivable. Criteria for these short-term loans are often tied to overall inventory value and even to the age of inventory items. Incorrect inventory valuation could mean less short-term credit available for cash flow.
Depending on the size, WIP, and length of time held, inventory can impact income taxes for the enterprise. Some methods of inventory valuation are better than others for income tax assessment.
While there are many variations of inventory valuation methods, the three most common are First in First Out (FIFO), Last in First Out (LIFO), and Weighted Average Cost (WAC). Which method a manufacturer chooses will depend on the industry, the value of the materials, and the company’s finance strategy.
First In First Out inventory valuation relies on the assumption that goods are sold in the purchase order. FIFO is the most used valuation method and is a simple, easy method for costing. There are advantages during an inflationary period as the ending inventory can have a higher value resulting in a lower COGS and better gross profit margin. However, it’s less accurate for costing in cases where prices may spike due to supply chain disruption, and it’s less advantageous for taxation.
Last in First Out relies on the assumption that new stock is sold first. While this may sound counterintuitive, there are benefits to the method. If a manufacturer knows that costs will increase within accounting periods or from period to period, selling the first in inventory impacts COGS to allow them to report lower profitability. This method reduces the income tax burden on the business.
If a company’s inventory doesn’t vary significantly between accounting periods, they may choose to use the Weighted Average Cost method. Here, all items purchased are averaged on a cost basis. One example would be a manufacturer of a commodified product with steady production, stable and predictable growth, and a small number of raw material SKUs. The WAC method will allow the company to capture an accurate cost value because the numbers won’t change much over time and predicting potential change is easier.
You’ll choose the valuation method that fits your company’s products, markets, and industry. But valuation is so critical that relying on a strong software solution is how to lock in the highest degree of accuracy. While others are still scratching away with pencils and staring at spreadsheets, you can be ahead of the game taking next-level steps like automating purchases and linking them to distribution logistics.
Plex’s Smart Manufacturing Platform helps modern day manufacturers like you better manage their inventory, regardless of your chosen valuation method. Learn how right here.