Inventory Valuation & Accounting Methods for Every Business
July 17, 2020
An online brand selling galaxy lamps has seen consistent order volume in the past year. The following year, they started to see a dip in profit. Why? The cost of manufacturing their high-demand product had gone up, which means the value of their product increased.
One of the most important aspects of inventory accounting is knowing how much your inventory is worth. Similarly, inventory valuation impacts the cost of goods sold (COGS) and is a critical metric in determining the overall financial health of your business.
In this inventory valuation guide, we’ll review the critical aspects of inventory valuation, the different methods used, and how to have inventory control at scale.
What is inventory valuation?
Inventory valuation is the calculation of how much your inventory is worth at the end of a financial year or accounting phase. Knowing and keeping track of inventory value can help you make better business decisions on how to track and manage ecommerce inventory, so you can stay profitable.
Top inventory valuation methods
There are several inventory valuation methods commonly used, but it’s important to choose the right one for your ecommerce business. Below, we break down the four most common methods, and the pros and cons of each.
1. WAC (weighted average cost)
The WAC method of inventory valuation uses a weighted average to determine the amount that goes into COGS and inventory. This method is occasionally referred to as the ‘average cost method’ and is calculated as followed:
Cost of goods available for sale / Total units in inventory
The weighted average cost method is commonly used for businesses that have a high volume of inventory with items that are the same or very similar. For instance, if you sell basic t-shirts in different colors and sizes, you might have several SKUs, but the value of each item is the same.
One drawback to the weighted average method is that you might end up selling products at a loss. Why does this happen? If your costs recently went up and you’re calculating prices based on a standard markup of COGS, your pricing won’t reflect the actual value of an item.
2. Specific identification method
The specific identification method is a system for tracking every single item in stock individually from the time it arrives to when it is sold. This method is used for businesses that sell very different products that vary in value. Using this method, each item is tagged with its purchase cost and the additional costs incurred until it’s sold.
The biggest benefit of this method is accuracy. Because every single item is tracked, the chances of losing inventory are close to 0% because you can easily track when the numbers are incorrect by product type.
The major drawback of this method is that tracking and identifying all the items within a company’s inventory is only feasible for small businesses or startups. Large businesses that move a high volume of inventory daily can’t realistically track every unit.
3. FIFO (first-in, first-out)
The FIFO method assumes that the inventory produced first will be the first unit(s) to be sold and fulfilled. This method allows you to determine value based on inventory on hand despite any changes in COGS.
FIFO is a common method used by ecommerce brands because it’s easy to understand. Using this method, a business is unable to manipulate income by choosing which item to ship because the cost of a single item sold is always the old cost. Any inventory left during the end of the financial year does not affect COGS.
FIFO can be inaccurate when the cost to make the product increases significantly. If product costs triple but accountants use values from months or years back, profits will take a hit. It also does not offer any tax advantages.
4. LIFO (last-in, first-out)
The LIFO method records the most recently produced items as sold first. With LIFO, the costs of the most recent products purchased or produced are the first to be counted as goods sold. Using this method, the lower cost of older products will be reported as inventory.
Unlike FIFO, there are tax advantages tied to using LIFO. During times of inflation, LIFO results in higher COGS and a lower balance of remaining inventory. If COGS are higher and profits are lower, businesses will pay less in taxes.
LIFO isn’t a realistic inventory system. There aren’t many businesses that prefer to sell new inventory before old inventory (especially when it comes to selling products with a shorter shelf life like cosmetics or any products with expiration dates). If accounting or finance always uses the most recent purchases as the cost of goods sold, it can create a group of older inventory that’s never ‘sold.’
Why every business relies on inventory valuation
Knowing the worth of your inventory is important because it helps you remain profitable. Inventory valuation ensures that you’re pricing your products based on value. For accounting purposes, the value associated with your products impacts your balance sheets and your taxes.
Balance sheets and income statements
For a balance sheet to be complete, you’ll need to claim all inventory as an asset. The valuation accounts for COGS and assets, such as raw materials, unit costs, net income, and the monetary value of the inventory.
Your inventory valuation will directly relate to how you file your taxes. You don’t want to be audited by the IRS, so the right valuation method can help ensure your business is compliant and paying the right amount in taxes.
Some products, like electronics or game consoles, lose value over time. In order for a business to decide whether to stock up or run a flash sale to deplete inventory, they must know how much they will profit or lose on their current inventory.
Inventory valuation helps with budgeting, especially when it comes to choosing to stay with your manufacturer or supplier, or source a new one. Any aspect of your business that impacts your bottom line needs to be put into consideration.
After deciding how much your inventory is worth, you can decide how much you’re willing to spend to make and sell the product, and still make a profit.
Things to consider before choosing an inventory valuation method
The inventory valuation method you choose has a big impact on your business. It can affect everything from budgeting, taxes, inventory reorder quantity, and most importantly — growth profit.
Will prices stay stable over time?
The costs of producing and/or purchasing inventory can change as quickly as overnight due to macro or microeconomic changes. Depending on the type of product you sell, consider choosing a valuation method that is least affected by changes in raw material costs.
Are you willing to keep this type of valuation for the fiscal year?
It’s not a good idea to change your valuation during the middle of your fiscal year, so be sure you choose the right inventory valuation method that makes sense for your business.
If you change methods, you’ll spend a lot of time recalculating the value of your inventory, which isn’t recommended by most accountants. Changing inventory valuation methods too soon can result in inaccurate value amounts, which can impact your balance sheet.
The challenges of valuing your inventory
Unless you’re an enterprise-level brand that’s invested millions of dollars into inventory tracking, it can be a challenge to accurately calculate the value of your inventory.
For small and growing businesses, inventory valuation is easier when you work with an accountant. Proper inventory management is important too, and an order fulfillment company like ShipBob can make managing inventory easier.
“I used to have to pull inventory numbers from three places everyday and move all the disparate data into a spreadsheet. ShipBob has an analytics tab in their dashboard with all of this information, which is great for end-of-month reconciliations.”
Wes Brown, Head of Operations at Black Claw LLC
If you’re a growing ecommerce brand, you likely have thousands of units in stock. Without proper inventory management, it can be hard to calculate the current value of inventory.
If you’re stocking more inventory than you’re selling, you might also be paying too much in carrying costs, which eats away at profits. Proper inventory management is a key aspect of inventory accounting, and shouldn’t be overlooked.
“I felt like I couldn’t grow until I moved to ShipBob. Our old 3PL was slowing us down. Now I am encouraged to sell more with them. My CPA even said to me, ‘Thank God you switched to ShipBob. ShipBob provides me clarity and insight to help me make business decisions when I need it, along with responsive customer support.”
Courtney Lee, founder of Prymal
Geographically distributed inventory
For businesses with inventory stored throughout the United States or in international locations, it can add another layer of complexity in managing inventory.
ShipBob operates fulfillment centers across the globe. This allows ecommerce businesses to split inventory across locations so they can expand geographically and reach more customers while reducing shipping costs.
“As we started to hit that first inflection point of growth, it became apparent we needed to look for a 3PL that could help us expand geographically in the US and also drive down shipping costs and expenses.”
Michael Peters, VP of E-Commerce Operations at TB12
No matter where inventory is stored or how many locations utilized, ShipBob offers full visibility into the entire fulfillment process along with built-in inventory management software.
Cost of a good inventory audit
Inventory audits and inventory reporting have to be done consistently to keep your financial statements and stock levels on track. However, performing an inventory audit is a time-consuming process. And if done manually, can be prone to errors and inventory shrinkage.
By working with ShipBob, our technology tracks all your inventory across fulfillment center locations and makes it easier for both you and your accountants.
“We utilize ShipBob’s Inventory API, which allows us to programmatically retrieve real-time data on how many units of each product are currently stored at ShipBob’s warehouses. We currently use this API to generate custom reports to tie this inventory data into our accounting platforms.”
With ShipBob, counting and valuing inventory has never been easier
Knowing the value of your inventory can be a challenge without proper inventory management. Our proprietary ecommerce fulfillment technology comes with built-in inventory management that helps you better track inventory in real-time all from one dashboard.
“One of the greatest features of ShipBob’s software is the inventory management functionality, which lets us track inventory change and velocity over time. Being able to monitor which styles are selling quickly helps us always keep our best sellers in stock.
We’ve been able to get through our heaviest seasons while staying ahead of production using ShipBob’s inventory forecasting tools — even as our order volume more than quadrupled in less than a year.”
Ryan Casas, COO of iloveplum
To learn more about how ShipBob can help you improve your bottom line and help you stay profitable, click the button below to request pricing.