When prices rise which inventory method tends to result in lower income and a lower tax liability?

Every company that sells physical goods needs to determine the value of its inventory for accounting purposes. Since inventory typically accounts for a large portion of business assets, the way it’s valued can significantly affect the company’s profits, tax liability and asset value.

Companies can choose from several inventory valuation methods, and it’s important to choose the method that best fits your business. Once a company has chosen an inventory valuation method, it can be complicated to change it.

What Is Inventory?

For a company that manufactures or sells physical goods, inventory includes everything that goes into those products, such as raw materials, work-in-progress and finished goods. Consider the example of a company that makes coffee filters and ships them to retailers for sale to consumers. After manufacturing the filters, it needs to package them into the boxes of 50 filters that you see on the supermarket shelf. So in addition to the finished filters and the paper used to make them, the company’s inventory includes the cardboard boxes it uses to ship those items to retailers.

If the company also makes the packaging instead of buying it from someone else, its inventory includes the printed cardboard not yet assembled into package form, as well as the glue used to make boxes. Manufacturing the packages might be a multi-step process, so the company might have piles of half-made coffee filter packages sitting around. Those are inventory, too.

What Is Inventory Valuation?

Inventory valuation is the accounting process of assigning value to a company’s inventory. Inventory typically represents a large portion of the assets of any company that sells physical items, so it’s important to measure its value in a consistent manner. A clear understanding of inventory valuation can help maximize profitability. It also ensures the company can accurately represent the value of inventory on its financial statements.

Inventory Valuation Explained

There are several methods for calculating inventory value. For example, the First In, First Out (FIFO) method values inventory as though the first inventory items purchased are the first to be sold. The Weighted Average Cost (WAC) method is based on the average cost of items purchased.

The inventory valuation method a company chooses can affect its gross profit during an accounting period. Note that the choice of inventory valuation method is an accounting decision and not necessarily related to the way a company actually uses its inventory. For example, if a company uses FIFO valuation, it is not obliged to move the oldest inventory first.

Why Is Inventory Valuation Important for Businesses?

The way a company values its inventory directly affects its cost of goods sold (COGS), gross income and the monetary value of inventory remaining at the end of each period. Therefore, inventory valuation affects the profitability of a company and its potential value, as presented in its financial statements.

Selecting an inventory valuation method is also important because once a company has made its decision, it generally should stick to it. The IRS requires companies to commit to one method during their first year of filing tax returns, and to obtain permission if they want to change the method in subsequent years.

What Are the Objectives of Inventory Valuation?

The overall objective of inventory valuation is to help create an accurate picture of a company’s gross profitability and financial position. To calculate the gross profit listed on the company’s income statement, a company must subtract the cost of goods sold (COGS) from net sales (total sales — returns and discounts and any other income not related to sales). The basic formula for COGS at the end of any accounting period is:

COGS = Beginning inventory + Purchases – Ending inventory

As a note, COGS includes the direct cost of materials and labor required to create the good and doesn’t include indirect expenses such as marketing and distribution.

Therefore, the method a company uses to value its inventory directly affects its gross profit and income statement, which gives banks and investors an idea of financial performance. Inventory valuation also affects a company’s balance sheet, which lists the company’s assets and liabilities. Inventory is treated as a current asset for accounting purposes, along with cash, temporary investments, accounts receivable, supplies and prepaid insurance.

Costs Included in Inventory Valuation

At the end of an accounting period, inventory exists in a finished and unfinished state. How do you value that investment? To make a bicycle, you need parts. But you also need someone to put the parts together, and you also incur a range of other overhead costs. Inventory valuation accounts for all of those costs.

Direct labor. Companies spend a lot of money on labor, whether for salaried employees or hourly workers. But not all of that labor is expended making the products. Therefore, only the direct labor is included in inventory valuation. This includes wages paid to those involved in assembling the products, the payroll taxes paid by the company, pension contributions and any company-paid insurance coverage, such as medical, life and workers’ compensation.

Direct materials. Any materials and supplies used in manufacturing a product count as direct materials. This includes supplies that are consumed or discarded in the process, as well as any materials that are damaged and unusable. A good rule of thumb is any cost that varies with each unit of manufacture is a direct cost.

Factory overhead. Factory overhead covers all expenses incurred during the manufacturing process other than direct labor and direct materials. Examples include the salaries of people who are involved in producing inventory but not actually making the products, such as production supervisors, quality assurance professionals and materials managers. Factory overhead also includes rent, utilities, insurance, equipment setup and maintenance costs. It also includes the purchase cost of small factory tools that are fully expensed when acquired, as well as the depreciation costs of larger equipment.

Freight in. This is the transportation cost for the delivery of goods to the company. There is a matching freight-out cost if a company offers free or discounted shipping to its customers and absorbs the associated costs.

Handling. This includes everything involved in preparing a finished product for shipping: the labor involved in picking the inventory, packing it for shipment, generating a shipping label and getting the product onto a truck.

Import duties. A company may need to pay a duty on any imported materials or supplies used in producing its goods. Exceptions include items that are duty-free thanks to trade agreements or for other reasons.

Challenges of Inventory Valuation

Two basic challenges exist when valuing inventory: The company must determine the total cost of its inventory, and to do so, it must figure out how much inventory it has, which can be complicated.

Costing your inventory. The basic equation for the value of your remaining inventory at the end of an accounting period flows directly from the equation for COGS:

COGS = Beginning inventory + Purchases – Ending inventory

So it follows that:

Ending Inventory = Beginning inventory + Purchases – COGS

However, the value of beginning and ending inventory may not be as simple as it seems. Anything you cannot sell at full price — because of damage, obsolescence or even changes in consumer preferences — must be marked down and valued accordingly.

Determining the amount of inventory. This can also be more difficult than it may seem. For example, a company may have goods in transit and needs to decide whether to include those items in inventory. In addition, it may need to conduct physical inventory counts. Many companies tally inventory using a periodic inventory system. Under this system, companies conduct an assessment of inventory at the end of an accounting period. The alternative is a perpetual inventory system, which tracks every purchase order and sale and continuously updates inventory to reflect those transactions.

Top Inventory Valuation Methods

Companies generally have a choice of four different inventory valuation methods, each with its pros and cons. It’s important they consider all the potential advantages and disadvantages of each approach and choose carefully:

• First In, First Out (FIFO). This is the most intuitive and widely used method. It assumes that the first product a business sells is from the first (or oldest) set of materials or goods it bought and values the inventory accordingly. Generally speaking, this is the method that most closely matches the actual inventory costs.

  First-in goods are generally cheaper than those that follow because materials prices and other inventory costs tend to rise over time due to inflation. FIFO therefore generally results in a lower COGS and higher gross income than other valuation methods.

  FIFO does have two significant disadvantages. First, a higher gross income translates to a bigger tax bill. Second, during periods of high inflation, FIFO can result in financial statements that can mislead investors.

  Imagine you sell dry chickpeas by the pound. It’s a new business, so your beginning inventory is zero. You initially buy 60 pounds and subsequently purchase an additional 70 pounds and then 80 pounds to stay ahead of future sales demand. The price rises between purchases, as shown in the table. If you sell 170 pounds in the relevant accounting period at $1.50/pound, your revenue will be $255 and your gross profit will be $255.00 – $177.50 = $77.50.

• Last In, First Out (LIFO). This model assumes that the newest inventory is sold first. If the chickpea retailer used LIFO accounting, COGS would increase to $181.50 (see chart below) because the newest inventory was the most expensive. As a result, gross profit drops to $73.50.

  LIFO provides a more precise matching of expenses with revenue. It also raises COGS and lowers the company’s tax bill. But it often presents an out-of-date number on the balance sheet and can keep the cost of goods bought earlier in the inventory account for many years.

  Because the value of the remaining inventory at the period is lower than with the FIFO method, the total value of COGS plus ending inventory is the same — $221.50 — so anyone who reviews the business’s financials will see that the underlying situation is the same. Only the current tax bill has changed. Note that the company hasn’t magically achieved a permanent financial benefit: If it sells the remaining inventory in the next period, its COGS will be lower and its profits higher, so its tax bill may be higher, too.

• Weighted average cost (WAC). As the name suggests, WAC uses an average of all inventory costs. WAC is generally used when inventory items are identical. It can simplify inventory costing because it avoids the need to track the cost of separate inventory purchases when calculating profit and tax liability. The other advantage of WAC is that it reduces fluctuations in profit due to the timing of purchases and sales. Its most obvious disadvantage is that a WAC system is not sophisticated enough to track FIFO or LIFO inventories.

  Let’s say the chickpea retailer wants to simplify its accounting and obtains IRS permission to switch to WAC inventory valuation. COGS is now calculated based on the weighted average cost of the three chickpea purchases. Since the total purchase costs are $221.50 for 210 pounds of chickpeas, the WAC per pound is just under $1.055 ($221.50 / 210). The COGS of 170 pounds is $179.31, so the gross profit is $255.00 – $179.31 = $75.69. Note that the gross profit is between that yielded by FIFO and LIFO, as you would expect.

• Specific identification. This method tracks each individual item from purchase to sale. It generally makes no sense to use specific identification for identical products sold in the thousands. But a dealer in high-value, one-of-a-kind items like classic cars would use specific ID. Specific ID provides the most accurate record of the real inventory cost and profit, and it allows the company to measure the profitability of each item.

  If a company buys four cars for a total of $85,000 and sells them for $140,000, its COGS is $85,000 and gross profit would be $55,000 ($140,000 – $85,000). If it buys one additional car for $20,000 and sells it for $35,000 during the period, its COGS increases to $105,000 ($85,000 + $20,000), and revenue increases to $175,000 ($140,000 + $35,000), for a gross profit of $70,000 ($175,000 – $105,000). The big jump in profit from one additional item makes it clear why the business would want to know the value of each item.

Choosing the Right Inventory Valuation Method

There are no absolute rules about which inventory valuation method is best for a given organization, but let’s summarize the suitability of each inventory method:

• FIFO tends to produce the highest gross income during the current period, LIFO the lowest, and WAC something in between. This assumes a typical inflationary environment in which the cost of supplies generally rises over time. Consequently, FIFO generates the highest taxes and LIFO the lowest, with WAC again in the middle.
• LIFO is allowed under U.S. Generally Accepted Accounting Principles (GAAP) but not under International Financial Reporting Standards (IFRS). So LIFO can currently be used in the U.S. but not in many other countries.
• One advantage of LIFO is that it matches recent revenues with recent costs, minimizing the effects of inflation or deflation.
• Specific ID is the natural method when you, your investors or your customers want to know the cost as well as the selling price of every unit. People involved in buying and selling art may want to know how the price of a particular Rembrandt changed from the year in which it was last bought to the year in which it was sold.

Though FIFO, LIFO, WAC and specific identification are the most common inventory valuation methods, others exist. They include:

• Highest In, First Out (HIFO): Companies sell the highest-cost inventory first.
• Lowest In, First Out (LOFO): Companies sell the lowest-cost inventory first.
• First Expired, First Out (FEFO): Companies sell the earliest-expiring inventory first.

Using Software to Manage Inventory Valuation

Inventory valuation can become very complex, especially as businesses grow. A company may buy hundreds or thousands of different items for resale or components to build its products, and it must assign costs to each product to accurately calculate profit and tax liability. Attempting to manage and monitor inventory finances with spreadsheets can become extremely cumbersome, time-consuming and error-prone.

Leading financial management software supports the most popular inventory valuation methods to automate the tracking and calculation of inventory costs. That helps give leaders a clear, accurate and up-to-date financial picture of their business at any time, and also reduces the burden of creating financial statements. Using software to manage inventory valuation can increase accuracy and allow staff to focus on more valuable tasks.

The choice of inventory valuation method is an important decision for any company. For many businesses, inventory represents a significant percentage of their total asset value. The way a company values that inventory can directly affect its COGS, profit and tax liability, and once it chooses a method, it generally has to use it for an extended period.

Inventory Valuation FAQs

How is inventory valuation calculated?

There are several methods for calculating the value of inventory. The First In, First Out (FIFO) method values inventory on the basis that the first inventory items purchased are the first to be old. The Last In, First Out (LIFO) method assumes that the most recently obtained inventory is sold first. Weighted average cost (WAC) takes the average inventory cost. Specific Identification tracks the cost of each inventory item.

What is the best method of inventory valuation?

Each inventory valuation method has advantages. Many companies use the FIFO method, which typically most closely matches the actual cost of inventory to its sale price; however, it can result in a higher gross income and taxes. The LIFO method matches current revenue to recent expenses, but it is not permitted under accounting rules in many countries. Weighted average cost can simplify accounting. Specific identification can make inventory tracking more complicated but is useful for companies that sell high-value or one-of-a-kind items.

What is included in valuing inventory?

A broad range of costs are included in inventory valuation. They include direct labor and materials, factory overhead, freight-in, handling and import duties or other taxes paid on a company’s inventory purchases.

Is inventory valued at cost or selling price?

Inventory is generally valued based on cost. Calculating cost can get complicated, depending on the type of business and the inventory valuation method used. To determine the total cost of inventory, the company first has to determine how much inventory it has at all stages of production. It needs to calculate all the materials, labor and other expenses associated with that inventory. And it also must pick an inventory valuation method.