Q&A: VALUATION OF INVENTORY

Q: What are the common methods of valuation of inventory?

A: There are three common and notable ways to perform valuation inventory. They are the FIFO method, the LIFO method, and the weighted average (or average cost) method. However, there are others, but these three methods are the most common, especially among trading and manufacturing enterprises.

Each method attempts to solve for ending inventory, a popular inventory calculation

FIFO (First-In-First-Out) Method: This method assumes that the first items added to inventory are the first ones sold. It follows the chronological order of when items were acquired.

To calculate ending inventory, you take the cost of the oldest inventory items still on hand.

LIFO (Last-In-First-Out) Method: In contrast to FIFO, LIFO assumes that the last items added to inventory are the first ones sold. It follows the reverse chronological order of acquisition.

To calculate ending inventory, you take the cost of the most recently acquired items still in stock.

Weighted Average (Average Cost) Method: This method considers the average cost of all items in inventory, regardless of when they were acquired.

To calculate the average cost per unit, you divide the total cost of inventory by the total number of units.

Ending inventory is then valued at the average cost per unit multiplied by the number of units still on hand.

Each method has its implications on financial statements and tax obligations. FIFO tends to result in higher net income during periods of rising prices, while LIFO often leads to lower taxable income but may not accurately reflect current market prices.

The weighted average method offers a middle ground, providing a more balanced representation of costs.

Choosing the right method depends on factors like the nature of the business, industry standards, and specific financial goals. It’s also essential to note that the chosen method should be consistently applied for accurate financial reporting and comparisons over time.