How to Manage Business Inventory and Its Value
After you record the receipt of inventory for your business, you must manage the inventory you have on hand. You also must know the value of that inventory. You may think that as long as you know what you paid for the items, the value isn’t difficult to calculate. Well, accountants can’t let it be that simple — you need to choose from five different inventory valuation methods.
Inventory valuation methods
Here are the five different ways to value inventory in a business:
LIFO (Last In, First Out): You assume that the last items put on the shelves (the newest items) are the first items to be sold. Retail stores that sell non-perishable items, such as tools, are likely to use this type of system. For example, when a hardware store gets new hammers, workers probably don’t unload what’s on the shelves and put the newest items in the back. Instead, the new tools are just put in the front, so they’re likely to be sold first.
FIFO (First In, First Out): You assume that the first items put on the shelves (the oldest items) are sold first. Stores that sell perishable goods, such as food stores, use this inventory valuation method most often.
For example, when new milk arrives at a store, the person stocking the shelves unloads the older milk, puts the new milk at the back of the shelf, and then puts the older milk in front. Each carton of milk (or other perishable item) has a date indicating the last day it can be sold, so food stores always try to sell the oldest stuff first, while it’s still sellable.
Averaging: You average the cost of goods received, so there’s no reason to worry about which items are sold first or last. This method of inventory is used most often in any retail or services environment where prices are constantly fluctuating and the business owner finds that an average cost works best for managing his Cost of Goods Sold.
Specific Identification: You maintain cost figures for each inventory item individually. Retail outlets that sell big-ticket items, such as cars, which often have a different set of extras on each item, use this type of inventory valuation method.
LCM (Lower of Cost or Market): You set inventory value based on whichever is lower: the amount you paid originally for the inventory item (its cost), or the current market value of the item. Companies that deal in precious metals, commodities, or publicly traded securities often use this method because the prices of their products can fluctuate wildly, sometimes daily.
After you choose an inventory valuation method, you need to use the same method each year on your financial reports and when you file your taxes. If you decide you want to change the method, you need to explain the reasons for the change to both the IRS and to your financial backers. If you’re running a company that’s incorporated and has sold stock, you need to explain the change to your stockholders. You also have to go back and show how the change in inventory method impacts your prior financial reporting and adjust your profit margins in previous years to reflect the new inventory valuation method’s impact on your long-term profit history.
Choosing the best valuation method for you
The key to choosing an inventory valuation method is the impact on your bottom line as well as the taxes your company will pay.
FIFO, because it assumes the oldest (and most likely the lowest priced) items are sold first, results in a low Cost of Goods Sold number. Because Cost of Goods Sold is subtracted from sales to determine profit, a low Cost of Goods Sold number produces a high profit.
The opposite is true for LIFO, which uses cost figures based on the last price paid for the inventory (and most likely the highest price). Using the LIFO method, the Cost of Goods Sold number is high, which means a larger sum is subtracted from sales to determine profit. Thus, the profit margin is low. The good news, however, is that the tax bill is low, too.
The Averaging method gives a business the best picture of what’s happening with inventory costs and trends. Rather than constantly dealing with the ups and downs of inventory costs, this method smoothes out the numbers used to calculate a business’s profits. Cost of Goods Sold, taxes, and profit margins for this method fall between those of LIFO and FIFO.
QuickBooks uses the Averaging method to calculate Cost of Goods Sold and Inventory line items on its financial reports, so if you choose this method, you can use QuickBooks and the financial reports it generates. However, if you choose to use one of the other inventory methods, you can’t use the QuickBooks financial report numbers. Instead, you have to print out a report of purchases and calculate the accurate numbers to use on your financial reports for the Cost of Goods Sold and Inventory accounts.
Check with your accountant to see which inventory method he or she thinks is best for you given the type of business you’re operating.