Inventory valuation refers to the practice of accounting for the value of a business’ inventory. Business inventories refer to all the supplies that a business requires to operate, and that are either utilized in the production process or sold off to customers. For example, a bakery would consider inputs such as flour, sugar, or icing as raw materials inventory. Additionally, the bakery could consider fresh baked goods as sales inventory that is awaiting purchase from customers.
Generally speaking, inventory is costly to hold, and operating with as small of an inventory as possible is oftentimes optimally profitable. Inventories require a place to hold them, a practice which may entail businesses to purchase storage facilities.
For example, a major clothing brand may need to rent out additional warehouse space in order to accommodate high inventory levels, which is a cost that might have been avoided if the business was able to operate safely with less inventory on hand.
Inventories also tend to lose value, or depreciate, over time. This is particularly true of industries where there are constant changes and advancements in the products offered on the market. For instance, a major electronics store will want to sell off all of its inventory as quickly as possible in order to prevent the items from becoming obsolete in the face of ever-advancing technology.
As obsolescence settles in, the business will then be forced to sell its inventory at a discount in order to clear inventory space for newer items.
How can we value inventories?
Inventory values can be calculated by multiplying the number of items on hand with the unit price of the items. In compliance with GAAP, inventory values are to be calculated with the lower of the market price or cost to the company.
For example, consider a coffee company with 100 pounds of coffee beans in inventory. The market price of coffee at the date of the inventory valuation was $2/lb., whereas the cost of the coffee to the company at the time of purchase was $1.50/lb. Thus, GAAP would require accounting to use the lower of the two numbers – in this case, the cost price of $1.50/lb. Thus, the inventory would be worth 100 lbs x $1.5/lb = $150.
Given this baseline, there are two main methods that auditors use to calculate the value of business inventories:
1. Item-by-Item Method
The item-by-item method utilizes the principle described above and calculates the inventory value based on the lower of cost price and market price. Below is an example of how this method would apply to a lawnmower producer:
Once we have identified which price is lower, we can calculate the value of each type of item in inventory by multiplying the price by the inventory quantity. Using the Item-by-Item method, we see that the total inventory value is $770,000.
2. Major Category Method
The major category method groups inventories into major categories. For our lawnmower example, we might group inventories by engine size. This method involves calculating the value of the inventories using solely market price and cost price. Using the same numbers as with the item by item method:
Using the major category method, we obtain an inventory value of $810,000.
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