Whether you run a small business or a full-fledged ecommerce enterprise, inventory value will be a key ingredient in your brand’s recipe for long-term success. Not only does inventory value help your company maximize its profitability and create attainable revenue goals, but it can also improve the accuracy of your forecasting efforts.
You must decide what method you will use to evaluate the current value of your inventory. There are two commonly used methods. Cost accounting is a more conservative inventory valuation method that values inventory based on purchase costs. Retail accounting, however, values inventory based on items' retail price.
This article dives deeper into the methods you can use to either value your inventory using the cost accounting approach or calculate your product margin using the retail accounting method. Keep reading to learn more about the ins and outs of inventory value—and discover how to calculate this essential value on your own.
So then, what is inventory valuation?
Inventory valuation is the accounting process used to determine your brand’s inventory value. A good grasp of inventory valuation can help boost your profits and strengthen the accuracy of your reporting. While there are several different methods for valuation, first in, first out (FIFO) and last in, first out (LIFO) are among the most common.
4 Inventory Valuation Methods
The most popular methods for inventory valuation include LIFO, FIFO, weighted average cost (WAC), and specific identification—all of which are discussed in more detail below.
1. Last In, First Out
Last in, first out is a valuation method where the products your company receives last have priority over any other inventory at your warehouse. In other words, retailers who use LIFO take the inventory they’ve received most recently and sell or ship those products first.
To calculate LIFO, you’ll first need to determine the cost of your beginning inventory (i.e., your most recent items), then multiply that number by the amount of inventory you’ve sold:
LIFO = Cost of Recent Inventory × Amount of Inventory Sold
While the LIFO method excels at preventing perishable items from going bad, it’s not always the most reliable indicator of ending inventory value. When the last units you purchased are sold first, then your inventory valuation is based on the cost of your oldest units. Unfortunately, this will not accurately reflect the current cost for said items. With that in mind, the most likely reason retailers use LIFO is to adapt to rising prices (like the current period of inflation).
For example, when inflation increases the market value of your inventory, LIFO allows those higher costs to be reported on your tax return at the end of the year. As a result, you’ll increase the cost of goods sold while reducing your overall taxable income. Therefore, some brands find LIFO beneficial because it can save on income tax and better match their revenue to the latest costs—even while prices are on an upward trajectory.
Overall, LIFO makes a good choice for merchants with consistent shipping rates and who manage their inventory via automation. On the flip side, if you’re using an outdated order management system (OMS) or experience a lot of staff turnover, LIFO probably isn’t the best option for your brand.
2. First In, First Out
First in, first out is essentially the exact opposite of the LIFO method. With FIFO, the first products your brand acquires are also the first items to be sold, used, or disposed of. More often than not, FIFO is the preferred way to keep inventory levels fresh—since your oldest stock takes priority over the newest items you’re bringing in.
To calculate FIFO, first determine the cost of your oldest inventory, then multiply that number by the amount of inventory you’ve sold:
FIFO = Cost of Oldest Inventory × Amount of Inventory Sold
The FIFO method is an excellent indicator of your brand’s ending inventory value. Because your older products have already been sold and shipped out, your newer products are still hanging out on your warehouse shelves—and those are the SKUs that are apt to reflect the current cost. That is to say, they’re an accurate representation of the cost of goods available for sale (which is an amount needed to run through your inventory valuation).
Generally speaking, FIFO works great for brands struggling to hit their key performance indicators (KPIs) despite being an established business. Conversely, the FIFO method likely won’t work as well if your business is just starting out and/or doesn’t have much in inventory quite yet.
3. Weighted Average Cost
Weighted average cost is a method for calculating the average cost of your inventory per unit. Finding your WAC is pretty straightforward—just divide your cost of goods available for sale by the total number of units currently in inventory:
WAC = Cost of Goods Available for Sale ÷ Total Units in Inventory
In many cases, the weighted average is used in conjunction with FIFO or LIFO to create a more well-rounded valuation of your inventory. Still, WAC is perhaps best when it’s too complicated to determine what you paid for each unit in your inventory. That’s because it’s much easier to use the WAC formula to find the average value of goods rather than looking at each individual inventory item.
In addition, the average cost method can be super helpful as prices are fluctuating. In today’s market, prices for raw materials and finished goods are changing all the time—but these constant markups/markdowns make it difficult to know what you paid for an individual unit. Luckily, WAC can simplify your inventory accounting and reveal the average cost of each SKU (which plays a big part in finding your ending inventory value).
Companies that can benefit from weighted average cost are those that order inventory regularly and experience relatively fast inventory turnover. Even with a high level of reordering, WAC can easily be calculated since you aren’t tracking every single purchase or each individual purchase price.
4. Specific Identification Method
The specific identification method tracks each product in your inventory—from its initial purchase to its final sale. More simply, specific identification assigns costs individually rather than grouping items together.
This inventory method is best utilized when a company cannot identify each individual SKU in its larger product catalog. Specific identification is not recommended for companies with identical products sold in the thousands. However, brands that deal with high-value or one-of-a-kind items can definitely benefit from this strategy. For example, car dealerships, art galleries, and jewelry stores often use specific identification to evaluate inventory.
To effectively use this inventory management technique, retailers must be able to:
- Track individual SKUs separately via manual or automated methods (like RFID tagging).
- Identify each individual SKU’s purchase cost and serial number.
If this information is known and accessible, companies can measure the profitability of each item in their product catalog. The specific ID method also provides the most accurate record of inventory costs and gross profits, which is foundational in calculating total inventory value.
How Extensiv Helps You Calculate Your Inventory Value
If your brand needs help with calculating its inventory value, Extensiv is at your service.
Automate Inventory Value Calculations
The Extensiv Order Management platform automatically records your inventory value in real-time once an order ships, reflecting the true cost of goods sold. Additionally, Extensiv automates your inventory valuation calculations with data from purchase orders, plus you can audit and reconcile your inventory values to ensure the accuracy of your historical data.
Fuel Your Growth with Inventory Forecasting
Once you’ve calculated your unique inventory value, Extensiv can use these insights to help you create inventory forecasting estimates and set up automations that fuel your growth. Extensiv’s innovative fulfillment software can automate the full scope of your operations so that your brand enjoys a smooth data flow across all orders, inventory, and purchasing.
To get started with Extensiv's solutions for brands, request a free demo from our team today!
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