Table of Contents
What is Inventory Valuation?
Inventory valuation is all about putting a dollar value on your inventory and making further decisions based on that value.
Zoho defines inventory valuation as
“An accounting practice that companies follow to find out the value of unsold inventory stock when they prepare their financial statements.”
The whole point is to quickly tell how much inventory you have available at the end of the month. For example, based on the value of the leftover goods. This allows you to determine how much your profit was at the end.
Two different types of inventory valuation methods are used in the retail business landscape:
- The Cost Accounting Method
- The Retail Accounting Method
The Cost Accounting Method
Cost accounting methods are the specific techniques and approaches to track and allocate costs.
A major roadblock for retail businesses is that they often purchase goods from multiple vendors. They buy goods at different costs and in varying quantities. This makes it hard to figure out your profit properly. Thus compelling you to assume the cost of your goods sold and determine profit by comparing it to the value of the remaining ending inventory.
The First In, First Out (FIFO) Approach
In the FIFO approach, you prioritize selling the inventory you bought first. For example, you bought apples in two batches of 20 on separate occasions, the first batch at $2 per apple and the second batch at $3 per apple. Now, your monthly sales were 25 apples. You will account for the first batch of apples, up to $40. Then, you’ll take five apples from the later batch and add them in at $15.
Thus, your cost of goods sold will come out to $55, while your inventory’s remaining value would be $45, as the remaining 15 apples all cost $3 each.
| First batch of 20 apples Cost: $2 Second batch of 20 apples Cost: $3 If monthly sales= 25 apples First 20 apples cost= $2*20= $40 Remaining 5 apples cost= $3*5= $15 Total cost= $55 |
In this way, you have mathematically estimated the value of your inventory. This value is based on the cost at which you bought it on a first-in, first-out basis of priority. The leftover inventory will be valued on the basis of the most recent cost.
The Last In, First Out (LIFO) Approach
The LIFO method of cost accounting is the opposite of the FIFO method. You sell the goods you bought last first and then price it.
So, considering the same example above, you would have sold $60 worth of apples from the second batch. Plus $10 worth of apples from the first batch, making your cost of goods sold $70 and your remaining inventory value $30.
| First batch of 20 apples Cost: $2 Second batch of 20 apples Cost: $3 If monthly sales= 25 apples Last 20 apples cost= $3*20= $60 Remaining 5 apples cost= $2*5= $10 Total cost= $70 |
The Weighted Average Cost Approach
As defined by the Corporate Finance Institute, “the Weighted Average Cost (WAC) method of inventory valuation uses a weighted average to determine the amount that goes into COGS and inventory. The weighted average cost method divides the cost of goods available for sale by the units available for sale.”
Consider that you bought a selection of 40 pens, all at different prices, totaling to $80. According to the WAC approach, you will divide the cost of the goods available for sale, i.e., $80, with the number of units available, i.e., 40, for a WAC of $2.
Now, if you sell 30 units, the cost of goods would be $60, and your remaining inventory will be valued at $10.
| Total cost of 40 pens= $80 Cost of one pen= 80/40= $2 Cost of 30 pens= 30*2= $60 |
The Retail Accounting Method
Retail accounting is a rather misleading term. Normally, you would expect it to be about bookkeeping and accounting for a retail business. But in reality, retail accounting is an inventory valuation and inventory management process. Retailers use retail accounting to get an estimation of the value of their available inventory without needing to assess and calculate it physically.
The retail accounting method is simpler than the cost accounting method. This method, rather than giving you a definitive answer to your inventory value and remaining stock, provides a rough estimation. So there is no need of counting inventory. This is useful if you are an online retailer and can’t take stock of your inventory frequently.
In the retail accounting method, rather than inventory being valued based on the cost of procurement, it is valued at the retail price. This method is best employed for retail businesses that need to mark up their inventory regularly by a consistent percentage, meaning they have a more-or-less fixed retail price across the board.
How to Use the Retail Accounting Method
The retail accounting method first requires you to plug the necessary data into the cost-to-retail ratio.
Cost to retail ratio= Cost of Inventory/Retail Price of Inventory ×100
This formula should give you the cost-to-retail percentage of your inventory.
For example, your business buys apples at $5 apiece and sells them for $10. Your cost-to-retail ratio will come out to 50%
| Cost to retail ratio Cost of apples= $5 Selling price= $10 Cost to retail ratio= 50% |
The next thing you have to hash out is the total inventory cost. Consider that you bought 200 apples first at $4 and then 100 more at $5. This would mean that your initial inventory was valued at $800, while your second batch totals $500. This means your total inventory cost before sales is $1300.
Next, you see how much you sold to get an idea of your revenue. In this case, consider that you sold 250 apples for $10. Your total sales would amount to $2500
All you have to do now is plug these numbers into the ending inventory formula, and voila:
Ending Inventory=total inventory cost-(total sales×cost to retail ratio)
Which would come out looking like this:
Ending Inventory=1300-(2500×0.5)
This means that your ending inventory value will reach an estimated $50.
Hence it’s all a matter of using the right formulae to estimate your inventory.
Conclusion
Cost accounting and retail accounting are the two main methods retailers use for inventory valuation. Which one they choose is largely subjective and dependent on the business structure. If you are a food retailer and deal in perishable goods, you are interested in selling the oldest procured item before it spoils. This means that FIFO is the ideal valuation method for you. If you work in a department that cannot distinguish between goods, such as cement or gravel. Here you can’t tell easily what item came first, and there’s no real benefit to selling based on procurement time. Then LIFO is the best approach for you. Retail accounting is best when your prices are consistent, and the markup percentage is also consistent.
Inventory valuation is important. Entrepreneurs should know how to get the job done or get in touch with cost accounting or retail accounting services.