Method of Inventory Valuation
Your business should choose a method of inventory valuation that best suits your industry.
Any business making or selling perishable goods should choose the first in, first out method as it ensures that goods are moved in the order received to prevent spoilage.
But there are several different types of inventory valuation methods the IRS will accept:
- FIFO – First In, First Out – as mentioned above, FIFO is ideal for perishables which include products like food, pharmaceuticals, chemicals, cosmetics, skin care, etc. When you only have a limited time to use ingredients before they spoil, you want to move them through your business and out the door to your customers as soon as possible to ensure they can be used while fresh.
- LIFO – Last In, First Out – This approach is only accepted in the United States. Industries such as petroleum apply this method as it offers a way to handle rising costs. There are certain tax advantages to this type of inventory valuation. Any industry facing rapid inflation can benefit from this inventory valuation technique.
- WAC – Weighted Average Cost – this method of valuation establishes a fixed cost across all inventories including recently acquired, inventory in stock and inventory in progress by finding the average cost of all types of inventories. (Similarly, a standard cost method of inventory valuation determines cost based on historical information and leaves that amount in place until a new calculation in performed).
- Specific Identification – Industries with customizable products hold inventory of varying values such as cars, jewelry, and furniture. To compensate for the wide fluctuation in value, this method entails adding up the costs for each individual finished good plus the total value of the balance of the inventory.
Challenges that Small Businesses Face with Inventory Valuation
There are several challenges that small businesses face when it comes to inventory valuation. Here are some of the challenges and their solutions:
1. Limited resources
Small businesses typically don’t have the broad resources large enterprises have, making it difficult to accurately value inventory. Without the proper resources, small business owners may be forced to rely on estimates or guesswork, which can lead to inaccurate valuations.
Solution: Utilize inventory management software
Inventory management software can help small business owners track inventory in real-time and automate the valuation process. This can save time and reduce the risk of errors.
2. Fluctuating prices
The prices of inventory items can fluctuate frequently, especially in industries where prices are determined by supply and demand, making it difficult to determine the true value of inventory at any given time.
Solution: Use the FIFO method
3. Seasonal inventory
Some businesses have seasonal inventory, which can be difficult to value accurately. For example, a retail store that sells holiday decorations may have a significant amount of inventory during the holiday season, but little or no inventory for the rest of the year.
Solution: Use the weighted average method
4. Obsolete inventory
Obsolete inventory is inventory that is no longer in demand or has become outdated. This can be a problem for small businesses that have invested money in inventory that is no longer valuable.
Solution: Conduct regular inventory audits
5. Human error
Human error is a common problem in inventory valuation. Small business owners may make mistakes when inputting data or calculating inventory values, which can lead to inaccurate valuations.
Solution: Provide training for employees and use inventory software like SOS Inventory!
Providing training for employees on proper inventory management and valuation techniques can help reduce the risk of human error. It is also important to have a system in place for double-checking inventory valuations to catch any mistakes.
Retail Method of Inventory Valuation
Since retailers buy finished goods from wholesalers and distributors, they may mark up their merchandise by a fixed percentage. When that is the case, using the retail method of inventory of inventory valuation can be helpful in determining an approximate inventory value. Note that it is only an estimation as it does not account for waste, theft, or obsolescence.
If the retailer marks some products up more than others, this approach is less effective.
The retail method of inventory valuation formula is as follows:
(Total Retail Value All Products – Total Sales) x Cost-to-retail ratio
Cost to retail ratio is a percentage that reflects how much of the retail price the cost represents.
All figures should represent the same time frame.
Managing All Types of Inventory Valuation Methods
SOS Inventory was designed to manage FIFO, LIFO, and weighted average inventory methods so you can accurately process all transactions to suit the accounting needs of your business. You can change the valuation method at any time, and it will not affect historical transactions; however, you may want to consult an accountant prior to making that decision.
SOS values inventory at the price at which it was purchased. The cost to acquire your inventory can vary throughout the year. If your costs rise over time, your method of inventory valuation will determine how to account for that change in value. For example, if one unit cost $10 in January but rose to $20 in April, your settings will indicate how to account for that difference.
SOS Inventory provides a consistent method of inventory valuation to all your inventory costs and quantities so your ledger will match your invoices. Our cloud-based software connects via API to QuickBooks Online to offer you a simple solution and bi-directional transfer of information to ensure your inventory data matches both in your SOS Inventory and QuickBooks Online accounts.
The inventory valuation process is infinitely simpler to manage with great software. For greater accuracy and easier inventory management, get started today with SOS Inventory.
