What Are the Four Methods of Inventory Valuation? Step-by-Step Guide

Inventory valuation is a critical aspect of accounting for businesses, as it directly impacts their financial statements and overall profitability. The value of inventory can affect everything from the cost of goods sold (COGS) to taxable income, so understanding different methods of inventory valuation is essential. The choice of inventory valuation method can also vary depending on the type of business, industry standards, and accounting regulations.

In this blog, we’ll explore the four primary system of inventory valuation: First-In, First-Out (FIFO); Last-In, First-Out (LIFO); Weighted Average Cost (WAC); and Specific Identification. Each system has its advantages & disadvantages, & choosing the right one depends on your business needs & goals.

What Are the Four Methods of Inventory Valuation? Step-by-Step Guide

1. First-In, First-Out (FIFO)

Definition: The First-In, First-Out (FIFO) method assumes that the first items placed in inventory are the first ones to be sold. In other words, under FIFO, the oldest inventory items are used to calculate the cost of goods sold (COGS), and the remaining inventory reflects the most recent purchases.

Example: Imagine you run a store that sells electronics. You bought 100 units of a tablet at $200 each in January and then bought another 100 units at $220 each in March. If you sell 100 tablets in April, under the FIFO method, you would record the cost of goods sold based on the $200 per unit price (the older inventory).

Advantages of FIFO:

• Accurate representation of inventory: Since older items are sold first, the remaining inventory reflects the most recent purchases, giving a more accurate view of current market prices.
• Higher profits during inflation: In times of inflation, FIFO can result in higher reported profits because the cost of goods sold is based on older, cheaper inventory. This leaves higher-priced, newer inventory in stock, which increases the total value of inventory on the balance sheet.
• Simple and easy to implement: FIFO is one of the most straightforward inventory valuation methods to use and understand.

Disadvantages of FIFO:

• Higher taxes during inflation: Since profits appear higher, businesses may face larger tax liabilities.
• Less accurate reflection of current costs in COGS: In a rapidly changing market, using the older inventory cost for COGS might not accurately reflect current replacement costs.

Best suited for:
Businesses that sell perishable goods or items with expiration dates (e.g., food, pharmaceuticals) typically use FIFO, as it ensures that older stock is sold before it becomes obsolete or spoils.

2. Last-In, First-Out (LIFO)

Definition: The Last-In, First-Out (LIFO) method assumes that the most recent items added to inventory are sold first. In contrast to FIFO, the newest inventory is used to calculate the cost of goods sold, and the older inventory remains in stock.

Example: Using the same electronics store scenario, if you sold 100 tablets in April, under the LIFO method, you would record the cost of goods sold based on the more recent $220 per unit price from March.

Advantages of LIFO:

• Lower tax liability during inflation: Since LIFO uses the more recent (and higher) inventory costs, COGS will be higher, which lowers gross profits and, in turn, reduces taxable income.
• Reflects current costs in COGS: The COGS reflects the most recent market conditions, providing a more accurate representation of current costs in financial reports.

Disadvantages of LIFO:

• Not accepted under IFRS: LIFO is prohibited under International Financial Reporting Standards (IFRS). It is only accepted under Generally Accepted Accounting Principles (GAAP) in the U.S.
• Lower net income: The higher COGS under LIFO means that reported profits are generally lower, which may not appeal to shareholders or investors.
• Distorted inventory value: Since older inventory remains in stock, the value of inventory on the balance sheet may not accurately represent current market prices.

Best suited for:
LIFO is often used by companies in industries where prices fluctuate rapidly, such as the oil and gas sector, as it helps reflect the latest costs in the COGS and minimize taxes during periods of rising prices.

3. Weighted Average Cost (WAC)

Definition: The Weighted Average Cost (WAC) method calculates the average cost of all inventory items available for sale during the period. This average cost is then used to determine the COGS and the ending inventory value.

Example: Let’s say you purchased 100 tablets at $200 each in January and another 100 tablets at $220 each in March. To calculate the weighted average cost, you would add the total cost of both purchases and divide by the total number of units:

WAC= 200 / (100×200)+(100×220) = 200 / 20,000+22,000 =210
So, the weighted average cost per unit is $210. If you sell 100 tablets, your COGS would be $210 per tablet, regardless of which batch the tablets came from.

Advantages of WAC:

• Smoothes out price fluctuations: By averaging the cost of all inventory, WAC reduces the impact of price fluctuations on financial statements.
• Simple to implement: WAC is easy to calculate and apply, especially for businesses with large volumes of inventory where it’s difficult to track the cost of individual items.

Disadvantages of WAC:

• Less accurate reflection of actual costs: Since WAC uses an average cost, it may not accurately represent the cost of goods sold or the value of remaining inventory if there are significant differences in purchase prices over time.
• Lower precision in inventory tracking: This method doesn’t track individual inventory items, which may be less precise than other methods like FIFO or LIFO.

Best suited for:
WAC is commonly used in industries where products are similar, such as manufacturing or retail, and it’s not practical to differentiate the cost of individual units.

4. Specific Identification

Definition: The Specific Identification method tracks the exact cost of each individual item in inventory. When an item is sold, its specific cost is used to calculate the COGS, and the remaining inventory consists of items with their unique costs.

Example: If your electronics store purchases 100 tablets at $200 each in January and then another 100 tablets at $220 each in March, under Specific Identification, you would know exactly which tablets were sold and record the exact cost for those units.

Advantages of Specific Identification:

• Precise and accurate: Since each item is individually tracked, this method provides the most accurate reflection of COGS and inventory value.
• Better suited for unique, high-value items: This method is ideal for businesses that sell expensive or customizable items, where tracking the individual cost of each unit is important.

Disadvantages of Specific Identification:

• Time-consuming and labor-intensive: Tracking the exact cost of each item can be difficult and requires more time and resources, especially for businesses with high inventory turnover.
• Not suitable for large-volume or identical items: This method is impractical for businesses that sell a large volume of similar or identical items, as it would be difficult to track individual costs.

Best suited for:

Specific Identification is typically used by businesses dealing with high-value items, such as car dealerships, jewelry stores, and art galleries, where it is essential to track each item’s individual cost.

Conclusion

The four main methods of inventory valuation—First-In, First-Out (FIFO); Last-In, First-Out (LIFO); Weighted Average Cost (WAC); and Specific Identification—offer businesses different ways to account for the cost of inventory. The method you choose can have a significant impact on your financial reporting, tax liability, and profitability.

• FIFO is ideal for businesses that deal with perishable goods or want to reflect a higher inventory value during inflationary periods.
• LIFO can be beneficial for reducing taxes in industries with fluctuating prices but is not allowed under IFRS.
• WAC provides a simple approach that smooths out price variations, making it suitable for high-volume businesses.
• Specific Identification is best for companies selling unique or high-value items where precise cost tracking is necessary.

Ultimately, the choice of inventory valuation system should align with your business model, industry requirements, & financial goals.