A Guide To Inventory Stock Valuation

Inventory has numerous processes and activities associated with it, including inventory stock valuation.

What Is Stock Valuation?

It is an accounting process performed by businesses to establish the monetary value of the stock that lies unsold in the business at the time of preparing financial accounts.

It also helps in calculating the turnover ratio of your stock, which allows more effective planning of inventory/material purchases.

The inventory value is basically the cost you incurred in acquiring it, and to prepare it for sale.

Your inventory value gives you a clearer picture of the financial standing of your company as well.

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Costs Included in Stock Valuation

At financial year end, a business is likely to have both finished products and work-in-progress along with raw materials.

It is imperative that you know what all of it is worth.

To create a product, you need several different materials and parts, but you also need people to put the product together, electricity, machine consumables, and so on.

1. Direct Labor

This is one of the biggest components of inventory cost.

Direct labor includes wages paid to laborers assembling the products, insurance premiums paid for laborers’ lives, health, and compensation, contributions to pension, and payroll taxes if any.

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2. Direct Materials

These are the actual materials, accessories, and supplies used in production, including any residual materials that are discarded, broken, etc.

Usually, expenses that change with every unit manufactured is a direct expense.

3. Factory Overheads

Any expense incurred during manufacture in addition to the two above, are overheads.

Salaries paid to materials and production managers, QA specialists, etc. are indirect – as they are not directly manufacturing the product.

Other overheads are insurance, rent, utility bills, equipment setup, and maintenance expenses, depreciation of large equipment , minor tools, and so on.

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4. Freight in

The cost of shipping materials and other supplies into the business is the freight in expense.

In case the company offers free shipping of its products to its customers, there will also be a freight out expense.

5. Handling

Picking, packing, labeling – whatever work is needed to ready the product for delivery, is referred to as handling expense.

6. Import Duties

If any supplies used in manufacture are imported, you may have to pay import duty, and that is included in the cost of the product.

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Stock Valuation Process

The process is pretty simple:

• A business has an initial inventory of a certain value at the start of the financial period.
• The quantity of inventory the company can sell in a given period is called Goods Available for Sale
• These goods are divided into cost of goods sold and balance stock at the end of accounting period. Both these stocks are shown in different parts of the records, so it is essential that the division is done perfectly.
• Sales are deducted from COGS to arrive at the gross profit, and this figure is displayed on the income statement.
• The balance stock is displayed in the company’s balance sheet, as a current asset.

Importance of Stock Valuation

• It affects profit levels as you can charge lower expense to cost of sold products when you value the balance stock at a higher value, and vice versa.
• As stock value is included in the company’s financial statements, it reflects the financial status of the business.
• Erroneous value of balance stock gets carried forward to the starting inventory balance in the next period, which means its impact is felt across several financial periods.
• Inventory valuation forms a major part of the current ratio; if the business has taken a loan, and it is not able to meet the target ratio (acceptable ratio of current assets to liabilities). The lender may ask for immediate repayment.

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• The gross profit can be calculated by computing the COGS and combining it with direct revenue earned. This figure is compared to the sales amount, with the difference being either gross profit or loss. Net income calculation is directly affected by under or over valuation of stock, and hence, you must calculate inventory value accurately.
• Proper stock valuation can help you impress investors and motivate them to invest in your business; however, be sure to be truthful. Purposefully valuing currency wrongly can land you in trouble.
• When you choose the right valuation method, you can show your shareholders that they are getting excellent returns on their investment, and they are more likely to recommend your business to other investors.

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• Inventory forms a huge part of the working capital, so it’s used to arrive at the liquidity level of the business. If the stock turnover ratio is high, it shows that the business is liquid.
• It can help maintain statutory compliance of regulations regarding treatment of inventories and other accounting policies.
• Stock valuation may determine the amount of income tax you have to pay.

Stock Valuation Methods

There are three main types of inventory stock valuation used – FIFO, LIFO, and WAC.

Let’s take a look at each of them in detail.

1. FIFO or First-In, First-Out

This method assumes that the products are sold in the order they are produced or procured.

So, the oldest products in stock are sold first.

It’s the most widely used valuation method as most business sell goods in the same order they were manufactured or produced.

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Example

A company bought 1000 units of a product at SAR 200 in one month.

They bought 500 units of the same product at SAR 250 in another month.

At the end of the accounting period, they had sold 800 units of the product.

This means they have (100-800) 200 + 500 units on hand.

Using FIFO, the first batch bought was sold, which means, the 800 units which were sold were from the first batch, valued at SAR 200.

Balance:

200 x 200 = 40000.
500 x 250 = 125000.

The ending inventory or balance stock is worth 40,000 + 125,000 = SAR 165,000

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Pros

• It is popular due to its simplicity, and the cost of every item sold being same, revenue cannot be manipulated.
• COGS is not impacted by inventory brought forward from previous period
• Usually, the price arrived at corresponds to actual cost involved
• The cost matches the actual cash flow as well as physical product flow across the warehouse
• The input cost is calculated in the order of production of the goods, purchases made at the end of the financial period don’t affect revenue calculations

Cons

• Prices normally rise over time but sometimes there can be a spike, especially agricultural products
• Paper calculations may not support actual inflated figures, resulting in income-expenditure mismatch
• In the case of inflated profits in assumption of regular inflation, heavier tax burden can occur, as compared to other methods.

ALSO READ: What is Negative Inventory and How Can you Prevent it?

2. LIFO or Last-In, First-Out

As you can imagine, this method is the exact opposite of the FIFO method, and assumes that the latest produced or procured goods are sold first.

If we take the same example as above:

A company bought 1000 units of a product at SAR 200 in one month.

They bought 500 units of the same product at SAR 250 in another month.

At the end of the accounting period, they had sold 800 units of the product.

So here, we assume that the last purchased products are sold first; which means, all of the 500 units in the second batch are sold, and 300 units from the first batch are sold.

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Ending inventory:

1000 – 300 = 700.
700 x SAR 200 = SAR 140,000

Pros

• You get tax benefits, thanks to higher COGS and lower inventory balance, especially during inflation – lower earnings on paper, and less tax burden
• As it accounts the latest cost, LIFO is more aligned with the actual profit figure
• Profits are lower as the equivalent net income is lesser, and this can help in determining the profitability
• It is better than the FIFO system, where showing of actual profits is concerned

Cons

• LIFO is not really practical – more so for products with low shelf life; everyone wants to sell products before they become stale or obsolete
• By using the latest purchases to determine COGS in accounting, you may have some inventory that never gets sold
• LIFO is not accepted by several accounting authorities

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3. Weighted Average Cost (or Avg Cost)

This method takes the average cost of products purchased or produced in a period, and is used by companies that have no variation in their inventory stock.

Example:

A company bought 1000 units of a product at SAR 200 in one month.

They bought 500 units of the same product at SAR 250 in another month.

This means they have a total of 1500 units of the product, for which they paid (200,00 + 125,000) or 325,000 SAR.

The weighted average cost would be SAR 325,000 divided by 1500 units, or SAR 216.66 per unit.

At the end of the accounting period, they had sold 800 units of the product.

This means 700 units remain; the cost of this ending inventory is :
700 x 216.66 = SAR 151,662.

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Pros

• It’s ideal for companies dealing in large quantities of inventory of identical or very similar items
• Its more systematic and scientific compared to LIFO and FIFO
• As only the price is considered, it’s easy to adopt, maintain, and audit
• It’s an ideal strategy when the products can’t be easily identified and the manner in which they reach the warehouse doesn’t matter.

Cons

• There is a possibility you may sell products at a loss as the price won’t reflect the actual value if costs spike suddenly
• There is often mismatch between inventory cost and market price of commodities

4. Specific Identification Method

This method is followed to be able to track the exact cost of each item in the inventory, usually because they are all unique items.

Every single item is identified, marked, and tracked for this method to be successful.

This can be done manually or through electronic tags, scannable stickers with serial numbers etc.

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Pros

• Highly accurate in calculating actual revenue and profit and for exact number of inventory items
• Little chance or lost or misplaced inventory
• Ideal for museums, art houses, etc.

Cons

• It can be very cumbersome and time-consuming
• Unique identifiers required for each item to know the cost and the revenue for each item

Choosing the Best Inventory Valuation Method

Your business goals and the market environment will determine the best method for your inventory valuation.

We discuss below the ideal method for a few scenarios:

1. For a Business Expansion Loan

If you want to apply for a loan, it is good to maintain inventory to show as collateral; the higher the value, the happier your lender will be.

The closing balance value of your inventory is an important criteria considered by lenders.

So, you must use the method which will help you show the highest value.

If the prices of inventory have been rising, use the FIFO method, and the LIFO method if they have been falling.

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2. To Satisfy Shareholders and Get more Capital

Profitable businesses can attract future investors, and keep current investors happy.

If the market is inflationary, the FIFO method will benefit you, but in a declining market, use the LIFO method.

3. To Save Taxes

To reduce tax liability, use LIFO method – on the assumption that market is inflationary.

ALSO READ: What is Demand Forecasting?

You can see how important stock valuation reports are; it may some cumbersome, but we have the ideal solution for you. Tranquil has a robust inventory management module that can automate and streamline this process, saving your time money, and effort. Schedule a demo to know more!