What is Inventory Valuation?
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 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 inventories. Additionally, the bakery could consider fresh baked goods as sales inventories that are awaiting purchase from customers.
Generally speaking, inventory is costly to hold, and operating with as small of an inventory as possible is often times more profitable. Inventories require businesses 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. It 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 would 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 need to sell its inventory at a discount in order to successfully move it out of its ownership.
How can we value inventories?
Inventory values can be calculated by multiplying the number of items or inventory 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 and cost to the company.
For example, consider a coffee company with 100 lbs 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 auditors to use the lower of the two numbers; in such 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 values 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 of $770,000.
2. Major Category Method
The major category method groups inventories into their major categories. For our lawnmower example, we can group inventories by engine size. This method involves calculating the value of the inventories using market price and cost prices solely. Then, the lower of the two numbers are used. Using the same numbers from the item by item method:
Using the major category method, we obtain an inventory value of $810,000.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: