It’s a great way to gain insight into the financial health of your business.

Q: How do I value my inventory?

A: For many business owners, inventory valuation is a major issue that impacts their P&L, balance sheet and taxes. The general rule of thumb is that inventory should be valued at what you paid for it and the market value (what it’s worth). Unless the inventory is obsolete, your inventory is generally valued at cost. But what is cost? Is it the last price you paid, the first price or the average price? In addition, what does cost include? Does cost include labor and overhead and freight or only the cost of the purchases? Consider the following:

• What is the effect of valuation inventory on the P&L? Your P&L and balance sheets are interconnected. How you value inventory determines costs of sales and therefore profit. The formula is as follows:

Costs of sales = (beginning inventory) + (inventory purchases) – (ending inventory)

Ending inventory depends on how you value inventory on your balance sheet. Therefore, the lower the inventory, the higher the costs of sales, which results in lower profit. Conversely, a higher inventory valuation results in lower cost of sales and higher profits.

• What are the different valuation methods? The three main valuation methods are:
  1. First-in-first-out (FIFO): This means your costs of sales is determined by the cost of the items you purchased the earliest. Inventory is comprised of the cost of the items you purchased the latest.
  2. Last-in-first-out (LIFO): This means your costs of sales is determined by the cost of the items you purchased the latest. It should be noted that depending on your industry, LIFO is not allowed for tax purposes.
  3. Weighted average cost (WAC): Means that your costs of sales is determined by the average cost of the items you purchased determined at the time of sale.

To demonstrate how these three valuation methods result in different inventory values, consider the following ending inventory scenario:

Company XYZ purchased 3,000 widgets during the year and sold 1,600, so it has 1,400 widgets in stock at the end of the year. (There was no beginning inventory.) The following is a schedule of purchases it made:

Total purchases = $3,350

The following is a schedule of sales of widgets:

Total sales = $3,040

Under FIFO, inventory would be valued at $1,600 (400 at $1.25 + 1,000 at $1.10). Cost of sales would be $1,750 ($0 + $3,350 – $1,600), and gross profit would be $1,290 ($3,040 – $1,750).

Under LIFO, inventory would be valued at $1,500 (1,000 at $1.00 + 400 at $1.25). Cost of sales would be $1,850 ($0 + $3,350 – $1,500), and gross profit would be $1,190 ($3,040 – $1,850).

Under WAC, you first determine the cost of sales then back into inventory. Cost of sales would be $1,768 (800 at $1.00 + 800 at $1.21), inventory would be $1,582 ($0 – $3,350 – $1,768), and gross profit would be $1,582. The $1.21 was determined as follows: $200 left from the first 1,000 units plus $1,250 from the second 1,000 units, divided by 1,200 units.

In the real world, you wouldn’t have to do any of these calculations yourself because the computer would do them for you. However, it’s important to know the differences. When costs are rising, FIFO would have the highest inventory valuation and gross profit. When costs are falling, LIFO would have the highest inventory valuation and gross profit. WAC estimates FIFO.

You should also note that once you pick an inventory valuation method, you generally have to stick with it. You cannot change every year without raising eyebrows from your bankers and other readers of your financial statements.

• What is included in cost of inventory? In addition to the cost of purchasing the inventory itself, costs of inventory may include all costs that make the inventory available for sale, such as duty, freight and, in the case of manufacturers, factory labor and overhead. However, very few growing businesses include anything but the actual cost of purchasing the inventory on their financial statements. The reasons are twofold: First, including the additional costs in inventory would decrease the cost of sales and increase profit. Most small businesses want to minimize taxes and therefore have an inventory value as reasonably low as possible. Second, fully costing the inventory is time-consuming without the right software program.

You should note that from a management point of view, it is essential that you also include those costs in your inventory costs–otherwise, you run the risk of undercharging for your products.