Inventory valuation methods and costing for pricing and accounting purposes
The method you use to value your inventory and the way you look at costing can have a significant impact on your small business.
In this article, we’ll look at a few strategies and tips on the different inventory valuation methods and the impact on your small business by using each.
Inventory valuation methods for pricing your products
Before we dive into valuation and costing, it’s important to make the distinction between price and cost. Although this might seem obvious, in the frenzy of running your business it is possible to miscalculate on total costs and lose money on a sale.
Price is generally referred to as the dollar amount charged to your customer, while cost is the amount your business pays for your inventory.
However, costing your inventory is not necessarily just what you pay for the goods. As a general rule of thumb, inventory should include all costs that are “ordinary and necessary” to put the goods “in place” and “in condition” for resale.
This means when considering your pricing, you’ll also want to include all the other “little” things that add up, such as:
- Shipping charges
- Custom and duties fees
Some merchants call these costs “non-vendor costs,” meaning that they are not included in the wholesale purchase price. In most inventory-control software packages, you can add these non-vendor costs to any purchase order as a dollar amount or as a percentage.
How to price your products appropriately
Once you put together all the different items you account for in your product cost, the next step is to choose how to price your product accordingly. There are a few methods that businesses use to do this:
Price Multiplier Method
The most common is simply to “double” your wholesale cost. Many businesses use a multiplier formula that multiplies the cost by 2 or 3.
Competitive Market Rates
It’s also very common to price your products based on what your competitors charge. You should always examine the market prices and your competition, but don’t follow this method exclusively when you do the costing. (For example, if your competitors charge a price that is lower than your cost, you’ll loose money.)
To be competitive, you may want to offer a lower price than your competition, but don’t go too low or consumers might wonder why your price is so low.
Inventory valuation methods for accounting purposes
Moving Average Cost
Moving average cost is a common way to track the value of your inventory. Your inventory cost is essentially re-calculated every time you make an inventory purchase. To accomplish this, you would take the total cost of the items purchased divided by the number of items in stock.
You would then use this number as your cost of ending inventory and the cost of goods sold for your accounting purposes.
One thing to keep in mind, however, is that you can only use moving average cost with a perpetual inventory tracking system that keeps up-to-date records of inventory balances. This is easily accomplished by using inventory software like inFlow Cloud. You could imagine how difficult it might be having to continually update your running average cost using something like an inventory excel spreadsheet.
Manual or Standard Cost
You can also keep track of your inventory costs by manually assigning the cost to your items; however, this is probably the most tedious way and not necessarily the most accurate, especially if your vendor prices change on a regular basis.
FIFO costing stands for First-In, First-Out. This method of costing essentially means that the oldest inventory items are recorded as a sold first. Your oldest purchasing costs will be used to calculate your profit.
For inFlow Inventory v3, you’ll be able to track your costing using FIFO.
LIFO costing, as you may have guessed, stands for Last-In, First-Out. This inventory valuation method means you use the cost of your most recent inventory purchases to calculate your profit.
Many US firms would use LIFO since it typically over-values their inventory and reduces the income tax they have to pay. However, the International Financial Reporting Standards (IFRS) have banned the use of LIFO, so many companies have turned back to FIFO. It’s also interesting to note that LIFO is only ever used in the US.
What are the differences between Average Cost, FIFO and LIFO Costing?
To illustrate these inventory costing methods better, we can look at an example.
Let’s say you made two separate purchases of:
100 basketballs at $10
200 basketballs at $20
And that at the end of your accounting period, you sold 50 basketballs.
Inventory Valuation Using Weighted Average Cost
In total, you have 300 (100+200) basketballs. You also paid $5,000 for all of them ($100 x 10 plus $200 x $20).
So your weighted average cost would be the $5000 cost divided by the 300 basketballs. This is equal to $16.67 per basketball.
After selling 50 basketballs:
Cost of Good Sold (COGS): (50 basketballs x $16.67 average cost) = $833.50
Remaining Inventory: (250 basketballs left x 16.67 average cost) = $4,167.50
Inventory Valuation Using FIFO Cost
In this instance, we use the costing from our first transaction when we purchased 100 basketballs at $10 each.
So, after selling 50 basketballs:
COGS: (50 basketballs x $10 FIFO cost) = $500
Remaining Inventory: 50 basketballs from the first transaction are still left costed at $10 each, as well as the remaining 200 basketballs from the second purchase at $20 each. So, (50 basketballs x $10 cost) plus (200 basketballs at $20 cost) is $4,500.
Inventory Valuation Using LIFO Cost
With LIFO cost, we’ll use the cost from the latest transaction when we we purchased 200 basketballs at $20.
Now, after selling 50 basketballs:
COGS: (50 basketballs x $20 LIFO cost) = $1,000
Remaining Inventory: The 100 basketballs that we purchased in the first transaction are still left at $10 each. We also have 150 basketballs from the second transaction at $20 each. So, (50 basketballs at $10 cost) plus (150 basketballs at $20 cost) is $3,500.
Comparing the Inventory Valuation Methods:
border:1px solid white;
|Cost of Goods Sold||$500||$833.50||$1000|
You can see above how using the LIFO method produces the highest costs of goods sold, which means you’ll have less profit to be taxed on. But again, keep in mind that you typically can’t use the LIFO method (the CRA or IRS, if they audit you, may make you re-do all the accounting using FIFO or another method, which is a lot of back-adjustments, then pay the extra tax plus a steep penalty for using LIFO).
To figure out which costing method might be right for your business, you can take a look at this article. You can also see more in-depth examples of inventory costing at here for even more in depth examples.
Too many numbers?
That’s why many small businesses rely on an inventory system such as inFlow to do all these costing calculations for you. You can run reports at the end of your reporting period to give to your accountant or enter the details into QuickBooks.
Interested? It’s quick and easy to try inFlow Cloud so you can see if it’s a great fit for your small business!