For manufacturing companies, few things are as important in finance departments than inventory costing. Here’s an overview of different inventory valuation methods.
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For manufacturing companies, few things are as important in finance departments than inventory costing. The valuation given to a company’s inventory will have a direct impact on gross profit, taxation and on its income. It also defines a company’s taxation and it informs stakeholders such as stockholders, owners, and partners of the true value of the cost of goods sold is at a given time period.
Cost of goods sold (COGS) has an inverse relationship upon gross profit. If a company’s COGS increases, gross profit decreases. On the other hand, if COGS decreases, gross profit will show a corresponding increase at the end of the measurable time period.
A Simple Process with Complex Meanings
The basic flow of inventory calculation is simple. Each company begins the time period with a beginning inventory valued in monetary units. When added with net purchases for the period, the total value is expressed as a sum called Goods Available for Sale. At the end of the time period, Goods Available for Sale are broken into two categories, ending inventory and Cost of Goods Sold – or COGS.
Great care must be taken to properly allocate COGS and ending inventory. The reason is that they will appear in different places on a company’s records. The Cost of Goods Sold is obtained by subtracting the valued amount from sales to arrive at the company’s gross profit. That value is then reported on the income statement. Ending inventory, on the other hand, is reported on a company’s Balance Sheet and is considered a current asset.
Different Inventory Costing Methods
Further complicating the process is the fact that different companies calculate inventory differently. This choice may be based on several factors and each company chooses the one that is best for their overall financial health, their business strategy and their long-term goals. For example, companies who make big-ticket items who fear increasing costs over time may use one method to reduce their taxable income, while another may look to maintain a strong balance sheet to attract investors and qualify for critical CapEx financing.
As every company is different, and each inventory costing method produces different outcomes, choosing a method that suits a company’s unique needs is crucial. While there are many different inventory costing methods, some of the most popular include:
First In, First Out (FIFO)
The concept behind FIFO is simple, a company will use its oldest acquired goods first. Because prices may rise over time, using FIFO means that the ending inventory is valued higher because line item valuation costs are higher. This means that the COGS is lower and gross profit is reported higher. It also means a higher taxable income.
FIFO is also simple and can be managed both manually and programmatically depending on the scale of the business. For small and medium-sized manufacturers (SMBs), this method can be tracked manually and then easily transferred to an MRP system or ERP system designed specifically for SMBs.
FIFO may also be used to comply with financing requirements depending on whether the company is a discrete or process manufacturer. Many small process manufacturing companies rely on “factored” financing – a type of bridge loan where the SMB is loaned short term financing (weeks or a few months) to cover cash flow when retailers pay on lengthy terms for the goods they purchase. In cases where factoring or short-term bridge loans are used, requirements usually dictate that the amount of short-term cash that can be borrowed against payables can only be up to 80-90% of inventory goods that are 180 days old or less. This is a strong motivator for SMBs who have tight cash flow and makes FIFO the best choice.
Last In, First Out (LIFO)
LIFO is the opposite of FIFO and means that the value of the inventory is expressed as the result of selling the newest goods first. The main benefit is that gross profit on a company’s income statement is lower and therefore its tax liability is lower as well as taxable income drops.
But taxation is not the only benefit. In addition to tax benefits, LIFO can be used as a hedge against inflation. In uncertain times, or in markets where prices are highly variable, seasonal or impacted by world events, LIFO means that companies can match revenues to the latest costs to help them manage the swing in pricing. It also means that a company will have to take fewer write-downs.
Weighted Average Cost (WAC)
WAC is a middle-ground method where the cost of goods available for sale is divided by the number of inventory units available to be sold. Manufacturers using WAC may choose this method for several reasons. One reason is when a company has little variation in its inventory. This can be true for both process and discreet manufacturers such as a factory that only produces a single, or limited line of one specific type of item in high volumes, or who produces as a built product with few product variations.
Another reason for using WAC is that it is beneficial for companies whose systems and processes are not sophisticated for tracking of FIFO and LIFO. SMBs just beginning to scale and whose staff wear many hats may find WAC easier to implement and adequate for their inventory needs.
A third reason WAC is a good choice for some manufacturers is in cases where inventory is highly commoditized and a cost per unit is not possible to assign to individual units or when the monetary fractions are so small that it is statistically irrelevant because all vendor costs are similar.
A final reason to use WAC concerns industries where items are highly mixed, and cost cannot be assigned per unit. For example, a manufacturer of toothpicks, due to the speed of the process and the unreliable characteristics of wood at such small sizes may understand that there will be splinters, losses, breakage and other problems included in the final product. In this case, WAC is a good indicator of inventory value.
First Expired, First Out (FEFO)
While there are many other inventory costing methods, FEFO should be mentioned based on high volume, high-speed process manufacturers who produce perishable items or items with a specific shelf life and expiration. This includes dairy, meat, pharmaceuticals and other consumables that must be used by a specific date. FEFO is like FIFO except that the specific expiration date for each product type must be considered as well. For example, a dairy manufacturer may make cheese with a shelf life of four weeks but also produce milk with a shelf life of only a few days. The expiration date must be considered, and inventory lost as a result of spoilage or slow sales accounted for.
Where a product is manufactured impacts the method of inventory costing used as well. Manufacturing in the US, companies follow accounting procedures according to Generally Accepted Accounting Principles (GAAP). However, in most other countries, the International Financial Reporting Standards (IFRS) must be used in selecting an inventory costing method. The GAAP allows FIFO, LIFO and WAC, while the IFRS only recognizes FIFO and WAC. Other differences include how inventory is recorded. Under IFRS, inventory must be recorded as the cost or the net realizable value or whichever is less, while GAAP recognizes cost or market value, whichever is less.
Choosing the Right Method
The inventory costing method chosen by a manufacturer should fit that company’s specific needs. Of course, where they are located will impact that decision. But also, the level of taxation within a country, the variation or volatility of prices within each market, the size and type of product made (process manufacturing versus discrete manufacturing), the per-unit cost, and other factors will need to be considered as well.