Inventory is not merely boxes on the shelf, but it grounds the financial performance, liquidity, as well as strategic decision-making in any business that deals with tangible goods. The volatility in the global supply chain, the inflationary cost pressures, and fluctuation in consumer demand have placed the inventory valuation among the most impactful accounting decisions that a company can ever make.
Since inventory is, in most cases, the biggest current asset of a company, the employed method of valuing inventory directly influences the reported profits, tax remittance, and strength of the balance sheet (Shopify).
New findings demonstrate that misvalued inventory may wrongly report profitability and even give investors and lenders a false impression of a business’s well-being. Everything is based on proper valuation in terms of loan approvals, acquisition negotiations, working capital planning, and pricing strategy, and conformance to accounting and tax standards.
No one-size-fits-all system: the various valuation systems, which include cost-based systems (such as FIFO, LIFO, and weighted average) and other alternative valuation systems such as retail accounting, all generate significantly different financial outcomes. Particularly in a high inflationary environment or in those markets with high input cost variability.
The correct method to use, timing, and the reason behind it are all strategic choices, which have a direct impact on gross profit, inventory turnover, taxation, and investors (Shopify).
The article will cover the traditional cost accounting methods and the retail inventory method so that the entrepreneurs and financial professionals will be put in a perspective, analyzing, and enlightening themselves to make wise valuation decisions in 2025 and beyond.
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 (The Retail Exec). 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 (High Radius). 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 at $15.
Thus, your cost of goods sold will come out to $55 (High Radius), 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 (High Radius). You sell the goods you bought last first and then price them.
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 (Corporate Finance Institute). 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 $80. According to the WAC approach, you will divide the cost of the goods available for sale, i.e., $80, by 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 (Corporate Finance Institute). 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 to count 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 (Corporate Finance Institute). 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.
The Needle Shifting the Valuation Choices:
Although most people believe that the policies on inventory valuation are fixed, firms fluctuate depending on the forces of the market and taxes. Current evidence of public filings demonstrates that the companies that report a LIFO reserve.
This is an indicator that using LIFO as their primary reserve has decreased from 220 in 2013 to only 121 cases in 2023, despite the fact that they still constitute a significant portion of the inventory and revenue (Lifopro). The trend itself can be considered a more general reevaluation of the valuation strategies in the context of varying economic environments.
Influence On Profit And Tax Returns:
The inventory valuation techniques have a material impact on reported profits, tax liabilities, and working capital. To illustrate, varying approaches can create 10%-30% variance to taxable income during inflation, i.e., the method used is not a bookkeeping technicality, but rather a strategic financial tool that can be used to influence cash flow, investor interpretation, and competitive standing.
Reporting Effectiveness & Accuracy:
Any company that optimizes its inventory approach reports a 15-25% superior financial reporting and a tax efficiency than any company that never re-evaluates its method choice. This indicator points out the value of operation of the correct method of valuation of a certain business model.
Trends in Supply Chain and Analytics:
Instant data and predictive analytics:
The valuation of inventory is no longer a routine accounting exercise that is periodically done.
New technologies in predictive analytics and real-time tracking (IoT, RFID, cloud systems) in 2025 will allow implementing dynamic valuation changes based on the current conditions of the market in real time, which will decrease the gap between the real and reported financial facts. This creates better working-capital measures and decision-making.
Frameworks of inventory optimization:
Latest research and business designs with stochastic optimization and machine learning are now intended to decrease the inventory carrying expenses by 10% -35% without falling service amounts (Accounting Professor) – a transformation that not only enhances efficiency in operations but also alters the way end-of-period inventory value is recognized in the accounting.
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.