Inventory is the stock of items present with the company which are to be used in the process of production. The thing with inventory is that inventories exist at all levels of production, be it at the pre-production stage, work-in-progress stage, and post-production and for sale stage. Inventory valuation then, is a very important part of cost accounting, because at any given time, the company needs to know what is the value of the inventory present with them, so that they will be able to manage it better, based on the demand and supply conditions in the market.
Methods of Inventory Valuation
Now it is a pertinent question if one were to ask the rationale behind there being different methods. Because at the outset it would seem that the items would be purchased and then sold all at a good price. But there lies the catch. Unfortunately enough, the prices of inventory items rarely stay steady over the assessment period over which the bookkeeping for the company is done, and so, valuation becomes a little tricky.
Suppose you had an inventory item which, at the start of the year costs your company about USD 1 per piece. Now if the price of this piece increases 10% each month, how would you be able to understand the value of the inventory? Has the USD 1 piece been used or the USD 1.1 piece?
The FIFO method of inventory valuation says that the inventory which came in first will be used first. Which sounds like a fairly logical and plausible situation. And best suited for raw materials that do not have a long shelf life. Hence the inventory which comes in first will be used or resold first. So, if we have 4 different inventory prices at say USD 1, USD 1.3, USD 1.9 and USD 2, and the company follows the FIFO method, then the US$ 1 inventory will be used up first and so on.
The FIFO is generally looked at as the better indicator of the inventory position. Secondly, by using up the inventory items which came in first and selling them, there is no risk of loss due to spoilage or obsolescence.
The LIFO method states that the inventory which came in last will be used up first. So taking the example mentioned above, the inventory worth USD 2 will be sold first then the inventory for USD 1.9 and so on. Assuming that the economy has an inflationary trend (and most of the time, it always does), the end result of the LIFO inventory valuation method will show that the value of the inventory in hand will be lesser than what it would be had FIFO been implemented. This is so because, in FIFO, the last, most expensive item is left in the inventory, while in LIFO, the first, most inexpensive item remains unsold.
The LIFO method also inflates the cost of goods sold, and has an impact on the final taxable profit of the company, and the earnings per share. LIFO may also lead to obsolescence and loss due to spoilage as the older items remain unused.
Weighted Average Method
The weighted average inventory valuation method assumes the weighted average cost of all the inventory purchased and then the items going out of the inventory are valued at that rate. In an inflationary economy, the FIFO would show a lower amount for the cost of goods sold, and the LIFO would show a higher cost of goods sold. The cost of goods sold for the weighted average method would fall somewhere between these two numbers.
These methods exist on simply the one assumption that the prices of inventory increase and decrease. If they were to remain the same throughout, then there would be no valuation methods whatsoever!