How to optimize your inventory valuation
If you want your business to thrive, you need to keep a close eye on your inventory levels. What is the best way to value your inventory? In this article, find out how to optimize the evaluation of your inventory.
What is inventory valuation?
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 refers 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 acquisition cost/weighted average manufacturing cost for entries, by dividing the acquisition or manufacturing cost by the quantity of items acquired or produced.
- The standard (pre-established) cost is a theoretical cost that is as close as possible to the (unknown) actual cost.
- The predetermined cost is set initially. It aims to value outgoing items by estimating the level of activity.
The term perpetual inventory designates the organization of accounts that record inventory movements 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.
How to calculate the value of your inventory?
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. So, what are the best ways to value your inventory?
FIFO vs. LIFO
Companies that sell perishable foodstuffs tend to choose the FIFO method (First In, First Out). This means that the business sells the oldest products in their inventory first. Let’s look at an example to better understand how the method works:
- January: a business buys 1,000 products at an acquisition cost per unit of €1
- February: the business sells 400 products
- May: the business sells 300 products
- June: the business buys 500 products at an acquisition cost per unit of €0.90
- August: the business sells 300 products
- September: the business buys 400 products at an acquisition cost per unit of €1.10
- December: the business sells 300 products
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.
The less frequently used LIFO (Last In, First Out) method is also an option. This method is particularly useful when dealing with a sudden change in the price of raw materials or merchandise. It can also be used for foodstuffs with a value that increases over time, such as cheese or wine. Removals are valued at the acquisition cost of the last merchandise purchased. If we take the same figures from the previous example, the ending inventory can be divided up as follows: 300 products bought in January, 200 products bought in June, and 100 products bought in September. The ending inventory value is therefore (300*1) + (200*0.9) + (100*1.1) = €590. The quantity in stock is identical in the two different methods, but it is valued differently.
The WAC method
For businesses that sell non-perishable merchandise that does not increase in value over time, the Weighted Average Cost (WAC) method is often used. This method can be used after each entry or at the end of the financial year. The business uses the following formula: WAC = (Purchase price of beginning inventory + Purchase price of new entries)/(Beginning inventory quantity+Quantity of new entries)
Let’s take the example given above:
- Beginning inventory in January: 1,000 units at €1
- June purchases: 500 units at €0.90
- September purchases: 400 units at €1.10
In this case, the WAC is (1,000*1 + 500*0.9 + 400*1.1)/(1,000+500+400) = €0.99.
What is a stock card ?
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.
How can inventory management software help you?
Make real-time inventory valuation easier with dedicated software. Erplain gives you a turnkey solution for your purchase orders and inventory tracking. We use the WAC method, which gives you an exact cost of goods sold at the end of the period!