Inventory Valuation Methods

Here are the most commonly used methods for inventory valuation:

1. First-In, First-Out (FIFO):

FIFO assumes that the earliest inventory purchased is the first to be sold. Under this method, the cost of goods sold is calculated using the oldest inventory costs, while the remaining inventory is valued based on the most recent costs. 

FIFO is often considered to be more closely aligned with the physical flow of goods and is widely used in industries where inventory items are perishable or subject to obsolescence.

Example: Let's say a business purchased 100 units of a product at $5 per unit, and later purchased 200 units at $6 per unit. If 100 units are sold, the cost of goods sold (on the income statement) would be calculated using the $5 cost per unit because that was the cost of each unit in the first purchase. The $6 products would still appear in the inventory (on the balance sheet). 

2. Weighted Average Cost (WAC):

The weighted average cost method calculates the average cost of all inventory items and assigns it to each unit sold. It takes into account both the cost of older and newer inventory. 

This method smooths out cost fluctuations and is often considered the best method for growing startups.

Example: if a business has 100 units of inventory purchased at $5 per unit and 200 units purchased at $6 per unit. The weighted average cost would be (($5 x 100) + ($6 x 200)) / (100 + 200) = $5.67 per unit.

3. Last-In, First-Out (LIFO):

LIFO assumes that the most recently acquired inventory is sold first. 

LIFO is not as commonly employed as FIFO or WAC methods. This is primarily due to the potential difficulties it can pose in scenarios with substantial fluctuations in inventory levels or concerns about inventory obsolescence.

Periodic vs. Perpetual Inventory Systems

Inventory systems determine how inventory is tracked and recorded. The two primary systems are:

1. Periodic Inventory System

Periodic systems involve physically counting inventory at specific intervals and making adjustments to the records accordingly. This method requires a physical inventory count to determine the Ending Inventory balance. For most businesses, a good practice usually involves doing a physical inventory count every month.

With the Ending Inventory, you will be able to adjust your Inventory and compute your actual Cost of goods sold (COGS) thanks to the formula we previously mentioned: Cost of goods sold (COGS) = Beginning Inventory + Purchases - Ending Inventory.

While periodic systems may be simpler and more cost-effective for smaller businesses with fewer transactions, they provide less real-time visibility into inventory levels.

For example, during the previous month, you have purchased $100k worth of inventory, and your sales reached $150k. You should know by now that your gross margin is not necessarily $50k as you need to properly determine your Inventory and Costs levels. You had a Beginning Inventory of $200k and thanks to your month-end inventory count you know that your Ending Inventory is $250k. Your Cost of goods sold is $50k ($200k+$100k-$250k) so your gross margin is actually $100k ($150k-$50k).

2. Perpetual Inventory System:

Perpetual systems use technology to track inventory continuously. Each sale and purchase is recorded with accurate inventory data. 

This method allows businesses to maintain a more accurate record of inventory levels and Cost of goods sold (COGS), streamlining reordering processes, identifying theft, and monitoring costs and margins in real-time.

But this usually requires an ERP (Enterprise Resource Planning) software to be implemented in the company which can take time and be costly for a small business.

Let’s take the previous example where you have purchased $100k worth of inventory. For each sale you made, your ERP software automatically accounted for its related Inventory and Cost of goods sold (COGS). So at the end of the month, your Inventory will be at $250k and you will also have accurate Cost of goods sold (COGS) of $50k and gross margin of $100k. 

Having an ERP software does not relieve you from doing periodic physical inventory count. The inventory levels from the system should be adjusted to match actual inventory counts. Inventory discrepancies could be explained by various reasons like inventory loss, system user mistake or even theft; and a good system will help you pinpoint the reason(s) swiftly.