Inventory value is one of the important things that every company must consider, especially since that value is generally considered to be the largest current business asset that a company owns. By knowing that value, companies will then be able to evaluate their costs of goods sold, and then determine the profits they make. In this article, we will talk about the importance of inventory value and what it is, as well as the best methods used to determine the value of inventory in companies.
What is inventory value?
Inventory value is the accounting process that companies apply to know the value of their unsold inventory at the time of preparing their financial statements.
That value is essentially the current business assets that the company owns, which must have a specific financial value in order to be recorded on the balance sheet.
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Why is knowing your inventory value important?
It is very important to determine your inventory value in your company, especially since it plays a key role in determining the inventory turnover ratio.
And then assisting companies in planning appropriately, and making the best decisions regarding the company’s procurement operations.
Determining the inventory value also helps in verifying the financial position of the company.
By clarifying its general financial position by determining the value of the closing inventory.
By knowing the inventory value also, companies will be able to easily determine their total income. by obtaining the total profit by comparing the costs of goods sold with the revenues achieved in the accounting period.
This means that knowing that value greatly affects the financial position of the company.
And in the event that an exaggerated value is provided, this in turn will lead to:
- Exaggerate current year earnings.
- Reduce the profits of the next years.
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4 inventory valuation methods
There are many methods that can be used to know the inventory value, which helps companies in determining that value accurately and knowing their financial position.
The following are the most important methods used to determine the inventory value of companies:
1. Weighted Average Cost (WAC) Method
One common method of determining inventory value is the inventory value and cost of goods sold based on the average cost of all items purchased during a period.
This is the appropriate method for companies that do not have a large variation in their inventory.
And the following mathematical formula is used in the calculations:
- Weighted average cost per unit = (total cost of goods in stock ÷ total units in stock).
2. Last in, first out (LIFO)
With this method of determining inventory value, it is assumed that the most recent inventory is sold first while the oldest inventory remains in stock.
The only reason to use this method is when companies expect the cost of inventory to increase over time and lead to price inflation.
By moving high-cost inventories to the cost of goods sold, companies’ reported profit levels can be lowered, and this allows companies to pay less taxes.
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3. Specific Identification Method:
Under this method, every item in your inventory is tracked from the time it is stored until it is sold, and it is usually used for large, easily identifiable items.
A prerequisite for this method is that you must be able to track each individual item using the RFID tag, stamped receipt date, or serial number.
While this method offers a high degree of accuracy in determining inventory value, it is limited to evaluating rare, high-value items that require such discrimination.
4. First in, first out (FIFO) method
This method is based on the premise that the first inventory purchased is the first to be sold.
And the assets remaining in the inventory are matched with assets that were purchased or produced most recently.
It is one of the most popular inventory valuation methods used by companies because it is simple and easy to understand.
During inflation, the FIFO method results in a higher value of ending inventory, a lower cost of goods sold, and a higher gross profit.