One might ask themselves the reason or need for taking inventory and/or how to value it, which can be confusing because of the constant change in price of inventory or raw materials. Choosing the right inventory valuation method is important as it can have a direct impact on the business’s profit margin due to the amount allocated to its cost of goods sold.
To begin, what is inventory? Inventory can be completed goods or raw materials that it takes to make the completed goods to sell.
The next question we need to answer is why do you need to do inventory counts? Inventory counts are important for several reasons: it helps to determine when to re-order, determines if there is shrinkage (possibly due to theft), for budgeting purposes, and it is used for the calculation in cost of goods sold.
Should all goods and material be counted in your inventory counts? That depends as some goods and materials, though in the warehouse, may not belong to the company. Goods counted in your inventory will depend on how purchase orders are done. FOB (Free on Board) Destination or Shipping Point. FOB Destination means that the items are property of the business selling them until they arrive at their destination and, therefore, should be counted in the inventory count even if they are enroute to a customer at the time inventory is being taken. Alternately, FOB Shipping Point means as soon as the purchase order is placed for the items, they should be removed and no longer counted in the inventory count.
Which type of measurement is right for your business? There are three accepted ways to measure inventory: FIFO, LIFO or Weighted Average. Which is right for your business depends mainly on the type of business (manufacturing, non-profit, government agency, etc.):
FIFO (First In, First Out) – The FIFO method means that you remove your oldest items from inventory first when sold. The state of the market for the goods or raw materials sold will determine the yield in gross profit. Inflation or rising prices for the goods or raw materials would yield a higher value of ending inventory and a lower cost of goods sold, resulting in a higher gross profit and vice versa if prices decrease.
LIFO (Last In, First Out) – The LIFO method means that you remove your newest items from inventory first when sold. This leads to the cost of goods sold being closer to current prices, and therefore yield a lower gross profit in times of inflation.
Weighted Average – The Weighted Average method means you average your cost during the period assigned to all items in inventory. Weighted average tends to smooth out price fluctuations during times of depression or inflation.
All three methods are allowed under Generally Accepted Accounting Principles (GAAP) and for IRS tax purposes. For financial reporting purposes you can change methods, but must disclose the method used and the reason for the change. For IRS tax purposes you are not allowed to switch back and forth to the one yielding the most advantageous tax situation.