5 Methods for Managing Inventory and Its Value
After you record the receipt of inventory, you have the responsibility of managing 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, so there are actually five different ways to value inventory:
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 nonperishable 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. (They try, but how many times have you reached to the back of a food shelf to find items with the longest shelf life?)
Averaging: You average the cost of goods received, so you don’t have 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 even in one day.
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 because the change impacts the value of your company and your profit margins. If you’re running a company that’s incorporated and has sold stock, you want to explain the change to your stockholders as well. 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.