For your business to thrive, it's essential to have a strong grasp of your stock levels. Effective inventory management involves a solid understanding of stock valuation methods, which are essential for making informed decisions. In this article, we will thoroughly explore each of these methods, including FIFO (First-In, First-Out), LIFO (Last-In, First-Out), the Weighted Average Cost (WAC) and the Moving Average Cost (MAC), as well as their respective advantages and drawbacks.
Inventory valuation comes down to evaluating the amount of inventory you hold of various raw materials and merchandise. Tracking entries and removals tells you the actual value of your product inventory in real time.
Inventory entries refer to the valuation of entries. The acquisition cost is used for the evaluation. For manufactured goods, the evaluation is based on the manufacturing cost. For manufactured goods, the evaluation is based on the manufacturing cost. Inventory holding costs and carrying costs (such as warehouse costs or inventory maintenance) are not taken into account. The following formula is applied for purchased items: Valuation of entries = Amount before taxes given on the product receipt + External purchasing costs (customs fees, transport costs, etc.) + Internal supply costs (direct and indirect)
Conversely, inventory removals consist of valuing removals. Every item stored can leave your premises at the same price at which it entered, with a calculation after each entry or a single calculation at the end of the period. When you are dealing with customized products, such as one-offs, or customizable products, it is easy to value removals. But that is not the case for most goods. Interchangeable fungible goods represent the majority of removals. There are a number of ways to value fungible goods:
The term perpetual inventory designates the organization of accounts that record inventory movements, so so you can know at any given time, including during the financial year, the inventory level in quantity and value. In accounting, the beginning inventory is considered to be a cost, whereas the ending inventory represents an asset on the balance sheet, meaning a definitively acquired resource. The beginning inventory of the financial year n corresponds to the ending inventory of the financial year n-1.
Before looking at how to calculate inventory value, let’s ask ourselves why valuing inventory is important.
Inventory valuation comes with a host of advantages. As well as helping you better manage your profitability, it helps optimize supply and ordering new raw materials and merchandise.
Inventory also plays an important role in accounting and tax. Inventory must be taken into account to determine the accounting and tax result. Inaccurate inventory valuation has a direct impact on a business’s income. This explains why the subject is so important.
FIFO (First In, First Out) is a common inventory valuation method. It is based on the principle that products acquired or produced first are also the first to be sold or used.
This method is particularly suitable for managing perishable products, such as foodstuffs, medications, or consumables, as well as products that can quickly become obsolete, such as electronics, computer equipment, etc.
Let’s look at an example to better understand how the method works:
At the end of the year, the inventory stands at 600 products. The company applies the FIFO method, meaning removals are valued at the purchase cost of the first merchandise acquired. The 1,000 products acquired in January have all been moved since August. Out of the 600 products in the ending inventory, 200 correspond to products bought in June and 400 correspond to products bought in September.
This gives an inventory value of (400*1.1) + (200*0.9) = $620.
LIFO (Last In, First Out) is the opposite of FIFO. This method assumes that the products acquired or produced last are the first to be sold or used.
This method is particularly useful when dealing with a sudden change in the price of raw materials or merchandise. LIFO is most common in industries such as car dealerships, gas and oil companies, and certain retailers. It can also be used for foodstuffs with a value that increases over time, such as cheese or wine.
In the United States and Canada:
In the United Kingdom:
In our example, let's assume that we are using a perpetual inventory system for the sake of accuracy.
If we use the same figures from the previous example, the ending inventory is divided as follows: 300 products purchased in January, 200 products purchased in June, and 100 products purchased in September.
Therefore, the value of the ending inventory is (300*1) + (200*0.9) + (100*1.1) = $590.
Depending on the chosen method, the quantity in stock remains the same, yet the valuation differs.
In a periodic inventory system, the Weighted Average Cost (WAC) is an often used method for businesses that sell non-perishable merchandise that does not increase in value over time. This method can be used after each entry or at the end of the financial year.
As a reminder, on a given period:
COGS = Beginning inventory (value) + Cost of Goods Purchased
Units available for sale = Total number of units in inventory + Purchases in units
In a perpetual inventory system, the Moving Average Cost (MAC) is an inventory valuation method that calculates the average cost of items after each stock acquisition. Typically, the MAC is suitable for non-perishable materials that can be stored over an extended period. It is calculated periodically, either with each new stock acquisition or at the end of a specific period. Calculations are typically applicable to perpetual stock systems, where inventory changes are recorded in real-time, often facilitated by inventory management software. This approach provides a precise representation of the current stock on hand and eliminates the necessity for physical inventory counts.
MAC must be calculated whenever a purchase is made.
Calculate your MAC for the first time at the beginning (units on hand value + new units value / Total number of units). Then you’ll simply keep calculating whenever an item is added to the stock.
MAC = (Previous MAC × previous quantity + new units cost) / total number of quantity
Let’s take the example given above:
In this case, the WAC is:
COGS = 1,000*1 + 500*0.9 + 400*1.1 = $1890
Units available for sale = 1,000 + 500 + 400
WAC = $1890 / 1900 = $0.99
Let's recall that at the end of the year, there are 600 products in inventory.
The value of the ending inventory is therefore (0.99*600) = $594.
MAC must be calculated whenever an item is bought.
1/ Initial MAC = 1,000 x $1 / 1,000 = $1
2/ In February and May, 700 units were sold. As a result, there were 300 units left in stock.
3/ In June, 500 units were purchased at a cost of $0.9 each. Let’s calculate our MAC:
MAC = (($1 x 300) + ($0.9 x 500)) / (300 + 500) = $0.9375
4/ In August, 300 units were sold. As a result, there were 500 units left in stock.
5/ In September, 400 products were purchased at a cost of $1.1 each.
MAC = ((500 x $0.9375) + (400 x 1.1)) / 900 = $1.0097
6/ In December, 300 units were sold. As a result, there were 600 units left in stock.
The MAC does not change.
The final MAC is $1.0097
Ending inventory is 600 x $1,0097 = $605.82 (compared to $584 with WAC)
In this simple example with only a few purchases and sales, you can already observe how calculations could become quite complex if there were additional movements. That's why it's highly recommended to use software like Erplain to calculate your MAC (Moving Average Cost) efficiently and accurately.
There are many ways to value inventory. Selecting the right approach hinges on accuracy and fit for a company’s needs. Factors to consider are:
The choice of inventory valuation method depends on the nature of the items in stock. If the items are interchangeable, two methods are possible: MAC and FIFO.
FIFO is preferred for perishable products. It is ideal for businesses where storage costs increase over time, as it minimizes expenses. However, FIFO has the drawback of reacting slowly to price fluctuations in supplies and goods, which can result in artificially high profits during inflation.
LIFO, while it can reduce expenses, can provide a distorted view of the company's profitability.
The WAC or MAC is more commonly used to assess raw material stocks that do not perish and can be stored over an extended period. It is the simplest method to implement.
A stock card (or sometimes referred to as Bin card or inventory card) helps you monitor inventory movements, meaning entries and removals. It offers an overall view of merchandise sales and deliveries. It should include a certain amount of information, including the exact product name, the location, the code, the reorder point, the date of each entry and each removal, and the remaining inventory. It is important to enter all this information in full and to update it in real time so you can order new merchandise at the right time. You can always create and manage your stock card using Excel, but when you have more inventory movements, inventory management software is a better option.
Recommended reading: Managing inventory with Excel: what are the pros and cons?
Understanding inventory valuation methods is crucial for making informed decisions. Choosing the most suitable method depends on your company's specific situation and industry.
Erplain provides a significant advantage in inventory and B2B sales management. By automatically calculating the MAC of your inventory in real time, Erplain allows you to have an accurate cost of goods sold at the end of a period, simplifying strategic decision-making for your business. Try it for free!
Recommended reading: Efficient Accounting When Managing Inventory