What is inventory?
To understand inventory valuation, you must first understand what inventory is.
Businesses can manage their inventory by managing raw materials, finished products, unsold items, etc. The companies can increase their revenue by decreasing their costs.
Businesses must reduce the waste of raw materials to minimize costs. The manufacturing industries maintain inventory using inventory management software. By maintaining the inventory, the manufacturer knows that they have enough stock to complete productions.
In accounting, inventory is referred to as stock in various stages of production and is a current asset. However, too much inventory on the balance sheet becomes a liability.
The real-world example of inventory that provides a better understanding is the raw materials, the details of the finished goods, the work in progress, the safety stock, cycle inventory, the book inventory, the transit inventory, etc.
Everyone is familiar with these three categories:
1. Raw Materials:
Raw materials are used in the production process for making the products. To put it another way, raw materials are simply materials used to create a single product.
For example, Potatoes, oils, etc. are raw materials used to manufacture potato chips.
2. WPI(Work In Progress)
The WPI mirrors the work that is still in the method of fulfillment. Presently, in the market, there are different programming accessible through which the companies or organizations can screen the work and sort out the normal chance to finish the request were time.
3. Finished Good
This is the last phase of the production output. The completed merchandise or items are prepared to sell on the lookout. The selling proportion of the completed item shows the benefits of the organizations.
In general, every company or business can focus on maintaining the three inventory listed items above, but they misunderstand MRO. Maintenance, Repair, and Operation Goods (MRO) is a term used to describe the maintenance, repair, and operation of goods.
What is Inventory Valuation?
Inventory valuation is an accounting system that assists corporations or enterprises in determining the exact value of their inventory at the end of the year.
Any organization’s asset is a huge volume of inventory, and a comprehensive grasp of the inventory helps organizations grow their sales. The organization can calculate the original quantity of their earnings and real-time incomes with the help of Inventory valuation.
According to accounting terms, businesses use three different types of inventory valuation procedures. But why is it necessary to have three separate methods of inventory valuation?
There are various corporations or businesses around the world that are registered in the United States and follow the Generally Accepted Accounting Principles (GAAP). Where enterprises in other countries use the International Financial Reporting Standards (IFRS).
Where GAAP uses LIFO, the IFRS does not. The corporations or businesses that are registered follow their own set of rules.
Furthermore, businesses value their inventory since it has a direct impact on their Cost Of Goods Sold (COGS) and gross profits at the end of the month or financial year.
It is critical for corporations or businesses to choose the right inventory valuation method. Because inventory valuation provides the company with an accurate picture of its profitability or net income.
For tax returns, the IRS (Internal Revenue Service) requires an inventory valuation method. If a company wants to change its methods, it must first obtain approval.
Also read: 7 PROVEN WAYS TO INCREASE THE PROFIT MARGIN FOR YOUR BUSINESS
Different Inventory valuation methods
Inventory valuation methods can be classified into three categories. Each strategy is unique, and businesses choose one based on their present corporate environment. A well-maintained accounting sheet gives the company an idea of which procedures to employ to maximize profits.
But keep in mind that once corporations have chosen their procedures, they will never be able to change them for all of their financial reports.
1. First In First Out(FIFO) Inventory valuation:
FIFO inventory valuation systems are the simplest to use in enterprises. This method’s work is identical to their name. The item or products were sold in the manufacturing companies’ production orders. In other universes, the products that are first made will be the first to sell on the market.
Because firms often sell the product that they first purchased, these approaches are frequently used or largely chosen by companies for inventory valuation methods. As a result, firms can maintain the actual flow of goods using this strategy.
The following is an example of how an organization can use the FIFO method to compute inventory valuation at the end of the month or financial year.
The store ABC of the Cloth purchased the 40 T-Shirts at Rs. 100 and the 30 T-Shirts at Rs. 200 after a week.
The merchant ABC sold 40 T-Shirts at the end of the month, thus they’ll calculate inventory valuation using the FIFO method…
Cost Of Good Sold = Quantity of the product x FIFO Cost = 40 x 100 = 4000
The remaining inventory is now determined based on the remaining materials at the end of the month.
Remaining inventory value = Quality of the product x cost = 30 x 200 = 6000
2. Late In First Out(LIFO) Inventory valuation:
LIFO is the opposite of FIFO when it comes to inventory value. Businesses can use the LIFO approach to sell products or materials that they have just purchased, as well as to manufacture the remaining products at the same time. The cost of goods sold (COGS) is higher than the inventory balances at the end of this approach.
We can simply understand how organizations or enterprises can calculate their inventory valuation using the LIFO method at the end of the month or financial year with the help of the example.
There is a corporation called ‘C’ that is a supplier of food supplies. They ordered 100 potato chip packets at Rs. 10 in the first order, then ordered 200 potato chip packets at Rs. 20 two days later.
By the end of the week, Company ‘C’ had sold out of 200 potato chips. The Inventory Valuation will next be calculated using the Last In First Out method…
Cost Of Good Sold = Quantity of the product x LIFO Cost = 200 x 20 = 4000
Now, at the conclusion of the week, firm ‘C’ calculates the remaining inventory based on the remaining potato chips packets that haven’t been sold out by the weekend.
Remaining inventory value = Quality of the product x cost = 100 x 10 = 1000
3. WAC(Weighted Average Cost) Inventory valuation:
These techniques are beneficial when a company’s or business’s inventory lacks enough variety. The average cost of all items is used to determine the COGS.
Here’s an example of how to figure out your WAC at the end of the month.
The watch mechanic creates two types of watches: ladies’ watches and men’s watches. Customers can choose from 20 ladies’ watches priced at Rs. 200 and 30 men’s watches priced at Rs. 300.
However, for all 50 watches (20 women watches + 30 men’s watches), the watch technician assigned an average value of Rs. 250 (20 x 200 + 30 x 300 / 50).
When the watch mechanic sells the 30 watches at the end of the month, they calculate the Cost of Sold Out according to the WAC…
Cost Of Good Sold = Quantity of the product x WAC Cost = 30 x 250 = 7500
The remaining inventory is calculated as per the remaining watches…
Remaining inventory value = Quality of the product x average cost = 20 x 250 = 5000
The objective of inventory valuation
The following are the two objectives of inventory valuation.
1. Determine the Gross Income
Companies calculate their gross income by determining inventory valuation. The following equation is used to calculate the gross income of the companies.
Opening stock + Purchases – Closing stock = Cost of goods sold.
By adjusting the opening and closing stock for the transaction, the cost of goods sold, or COGS, is calculated.
2. Secure the financial position
The company never assesses inventory valuation, therefore their costs are raised at the close of the financial year. Inventory valuation is used by organizations to decrease their costs.
The organization can secure its financial situation by calculating inventory valuation methods. In addition, well-maintained accounting sheets assist financiers in making investments in firms or businesses.
Which inventory valuation method is best for your companies?
To increase income, any organization must choose an inventory value approach. The companies or businesses they select can also have a big impact on overall costs of goods sold, gross income, and closing inventory.
The FIFO approach is commonly used by organizations or businesses. Because they provide an accurate profit outcome using the First In First Out approach.
Companies, on the other hand, are unable to adjust their inventory valuation methodology within their financial year. Before deciding on a method, businesses should check with an accountant to ensure that the results are accurate.
Recommended for you: BENEFITS OF USING AN INVENTORY MANAGEMENT SYSTEM
Inventory valuation and its application in businesses can open up plenty of options for profit growth. Accounting software is used by firms to manage their inventories and other costs. Companies can obtain an error-free accounting sheet using accounting software, and this sheet can be used to compute COGS. In addition, the company can figure out how much inventory they have left to calculate their net income.