How do you value that investment? To make a bicycle, you need parts. Costs Included in Inventory ValuationĪt the end of an accounting period, inventory exists in a finished and unfinished state. Inventory is treated as a current asset for accounting purposes, along with cash, temporary investments, accounts receivable, supplies and prepaid insurance. Inventory valuation also affects a company’s balance sheet, which lists the company’s assets and liabilities. Therefore, the method a company uses to value its inventory directly affects its gross profit and income statement, which gives banks and investors an idea of financial performance. The basic formula for COGS at the end of any accounting period is:ĬOGS = Beginning inventory + Purchases – Ending inventoryĪs a note, COGS includes the direct cost of materials and labor required to create the good and doesn’t include indirect expenses such as marketing and distribution. ![]() To calculate the gross profit listed on the company’s income statement, a company must subtract the cost of goods sold (COGS) from net sales (total sales - returns and discounts and any other income not related to sales). The overall objective of inventory valuation is to help create an accurate picture of a company’s gross profitability and financial position. What Are the Objectives of Inventory Valuation? The IRS requires companies to commit to one method during their first year of filing tax returns, and to obtain permission if they want to change the method in subsequent years. Selecting an inventory valuation method is also important because once a company has made its decision, it generally should stick to it. Therefore, inventory valuation affects the profitability of a company and its potential value, as presented in its financial statements. The way a company values its inventory directly affects its cost of goods sold (COGS), gross income and the monetary value of inventory remaining at the end of each period. ![]() Why Is Inventory Valuation Important for Businesses? For example, if a company uses FIFO valuation, it is not obliged to move the oldest inventory first. Note that the choice of inventory valuation method is an accounting decision and not necessarily related to the way a company actually uses its inventory. The inventory valuation method a company chooses can affect its gross profit during an accounting period. The Weighted Average Cost (WAC) method is based on the average cost of items purchased. For example, the First In, First Out (FIFO) method values inventory as though the first inventory items purchased are the first to be sold. There are several methods for calculating inventory value. It also ensures the company can accurately represent the value of inventory on its financial statements. A clear understanding of inventory valuation can help maximize profitability. Inventory typically represents a large portion of the assets of any company that sells physical items, so it’s important to measure its value in a consistent manner. Inventory valuation is the accounting process of assigning value to a company’s inventory. Manufacturing the packages might be a multi-step process, so the company might have piles of half-made coffee filter packages sitting around. If the company also makes the packaging instead of buying it from someone else, its inventory includes the printed cardboard not yet assembled into package form, as well as the glue used to make boxes. ![]() So in addition to the finished filters and the paper used to make them, the company’s inventory includes the cardboard boxes it uses to ship those items to retailers. After manufacturing the filters, it needs to package them into the boxes of 50 filters that you see on the supermarket shelf. Consider the example of a company that makes coffee filters and ships them to retailers for sale to consumers. What Is Inventory?įor a company that manufactures or sells physical goods, inventory includes everything that goes into those products, such as raw materials, work-in-progress and finished goods. Once a company has chosen an inventory valuation method, it can be complicated to change it. Since inventory typically accounts for a large portion of business assets, the way it’s valued can significantly affect the company’s profits, tax liability and asset value.Ĭompanies can choose from several inventory valuation methods, and it’s important to choose the method that best fits your business. East, Nordics and Other Regions (opens in new tab)Įvery company that sells physical goods needs to determine the value of its inventory for accounting purposes.
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