Inventory is one of the most crucial aspects of a business. If left unchecked it can cause more harm to you than you could ever imagine. Most sellers even after investing so much in their inventory fail to get the desired returns from it. As a result, their business suffers and they are not able to make an accurate estimate of their profits and losses. This situation is entirely different once methods of inventory valuation are put to use.
The methods of inventory valuation are popularly used for evaluating your inventory. You need to make sure that you have the correct estimate of your inventory at the end of the accounting year. This is fundamental to making correct predictions as well as keeping your records straight. Obviously you’ll want to know the correct calculations regarding the inventory you sold as well as the inventory you have with you. This way you can order new stock or choose to not order depending on whatever you have left with you.
No matter what kind of business you’re in, if you are selling physical products, they are your biggest asset. And you need to evaluate the positioning of your assets for your business. There are different methods of inventory valuation. However, choosing the one depends on the types of products you sell.
If you’ve heard words like FIFO, LIFO and Weighted Average cost, you already know some of the popular methods. But, there are other lesser known methods that might prove to be quite useful to you. So, don’t worry, if you can’t figure out where to get started. We’ve got all the information you need right here!
What is Inventory Valuation?
Inventory valuation is quintessentially an accounting practice. It is done to keep the count of the inventory in an organization. Sellers who use methods of inventory valuation are well prepared with their stocks and understand the profits and losses that it has brought to the business. In other words, by keeping an eye on your stock levels you can prepare your financial records with accuracy. And this is important not just for record keeping but also for you to grow as a business.
It is important to understand that your inventory possesses some financial value. And so you have to maintain records about what happens to that value for your online business. For example, inventory valuation asks you to update the value of each and every inventory and its whereabouts. It might not make sense when you’re doing it. But, when you take a look at it over a period of time, you find it useful. And that is because it tells you about your inventory turnover ratio.
One of the simplest examples of this is in the form of making a purchase decision at the start of a year. Suppose you sell sports equipment in the market. You initially purchased 1000 units of badminton rackets. At the end of the year you are left with 200 units. If you don’t take the leftover units into account, imagine what will happen. You will again purchase another 1000 units of the product next year and pile up most of it in your warehouse. On the contrary, if you had been using any methods of inventory valuation, you would have known that you still have 200 units of badminton rackets remaining.
Such mistakes in a business can lead to disastrous results. You might be either running out of inventory very soon or just piling slow moving inventory if you don’t recognize it. And obviously if you have the knowledge of existing inventory, you will not go on and purchase more quantities. Instead, you will first sell it off.
Why are Methods of Inventory Valuation Important for Small Businesses?
You might think that just because you’re starting to sell in the market, you do not need to adopt these technical practices. However, it is the other way around. Inventory valuation must be done independent of your business size. And that is because no matter how small or large your business is, you can’t escape the accounting process. Whether you sell 5 units or 500 units, you need to have transparent accounts for your business. And that’s where methods of inventory valuation help.
But, the concept of inventory valuation is not just limited to counting stocks. While this is only one part of it, the other part is taking account the price of the purchased stock. Once you know the quantities of your remaining stock, you need to settle on a rate so that you can get an estimate of the left over inventory.
The idea comes from the fact that inventory is purchased through different rates across the year. Sometimes you get it at a cheaper price, other times the rates are a little high. So, when you calculate the value of your inventory at the end of the year, you need to take into account the right price when the inventory was actually purchased.
However, this can be a challenging task for anyone to accomplish. With i=methods of inventory valuation it becomes simplified
What are the Popular Methods for Inventory Valuation?
Now that you know about inventory valuation and its importance, let’s take a look at the methods of inventory valuation-
You must have come across this term once or more in your life. That’s because FIFO is one of the most popular methods of inventory valuation. In fact, even if you didn’t know about inventory valuation, chances are you’re already using this method for your business. FIFO stands for First in First Out. This simply means that the inventory you purchased first must sell out first. For example, if you purchased 50 quantities of an inventory in July and another 50 units in December, you will first sell the stock you bought in July.
In other words, you sell your oldest inventory first. The principle comes into existence for the fact that price usually rises with time. And so you are left with the inventory that is valued higher than the others. The cost of your goods that are sole become lower because you’re selling your older inventory. Therefore, in the end you have higher profits to add to your accounts. In other words, you get more taxable income. Alternatively, FIFO helps you clear up your warehouse and doesn’t let any old inventory sit for long.
Another popular method of inventory valuations is LIFO. LIFO is the opposite FIFO. WHile in FIFO you sell your oldest inventory first, in FIFO you sell your newest inventory first. And so, LIFO stands for Last In First Out. From the above example, you would first sell the stock you bought in December, than the ones you bought in July. LIFO is not generally suitable in all scenarios. The cost of the goods sold is higher and therefore the profits are lower or the taxable income is lower.
Weighted Average Cost
One of the popular methods of inventory valuation is the weighted average cost. The weighted average cost methodology makes an assumption that your inventory is valued the same all throughout the year. Therefore, if you are selling a line of products where the purchase costs of the product remain more or less the same across the year, you can use this method. Companies dealing with crude oil can leverage weighted average cost as a method of inventory valuation.
This inventory valuation method is slightly uncommon. That is because it directly takes into account the price at which the goods are purchased. HIFO stands for Highest In, First Out. In other words, it means that if you have some inventory that is more expensive or higher priced, you will sell it first. On the other hand, the lower priced inventory sells later. The gross profits of the business in this case are lower and the taxable income drops as well. It makes more sense to adopt HIFO from a salesperson point of view. Since you would want to sell your expensive products first.
LIFO- Lowest In, First Out
One of the uncommon methods of inventory valuation, the Lowest In First Out is the opposite of HIFO. in other words, you sell the inventory that is lowest in costs first. Therefore, your total sold inventory at the end of the year is higher and ultimately gross profits are also higher. While this type of method might make your short-term revenue fall, it yields good returns in the long run.
First Expired, First Out
Just by looking at the name, you can easily guess what type of products fall into this category. If you are selling food, you must be using this type of inventory valuation technique. This means that you are selling the items that will likely expire first. And your fresh inventory sells after this. This absolutely makes sense in the food business.because if you let your old inventory keep on sitting in your warehouse, then it will perish.
Lower Cost of Market
This is yet another unpopular methods of inventory valuation. In this case you must evaluate your inventory based on the lower of the market or actual cost. This means that you evaluate your inventory on either the current market price or the original cost of the good, depending on whichever is lower. This technique makes more sense if you have long sitting inventory in your warehouse. Or your inventory has become damaged.
Retail Inventory Method
One of the last methods of inventory valuation is the retail inventory method. In this, you ignore your inventory units. You only make calculations based on the overall sales. Then you multiply this with the cost to retail ratio. In case you are selling handicraft items, this technique makes sense for your business.
Methods of inventory valuation can seem daunting. But, remember that there is no escaping from it. You have to dive deep into your inventory to estimate your profits. Therefore, you need to pick the one that suits your business the best. While FIFO works best for businesses, access your detailed requirements before making a decision. While taking care of your inventory, make sure you have a reliable shipping partner like Dash101 Logistics with you. This way you will be able to ship your inventory safely to your customer’s doorstep. With Dash101 Logistics you get to ship to 26000+ pincodes at the lowest costs starting Rs 23/500 gms.
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