Inventory drives your manufacturing operation, yet for many manufacturers it can be one of the most complex areas of financial reporting. In this blog post, we’ll examine what is involved in inventory valuation and the methods most commonly used to determine value—as well as others you should consider.
Let’s start with the basics. For manufacturers in the U.S., inventory valuation is the dollar amount of the items contained in your company's inventory. Think of it in terms of what the cost would be to get your inventory items in place and ready for sale. Your inventory valuation includes the costs of production—direct materials, direct labor and manufacturing overhead.
Generally accepted accounting procedures (GAAP) such as LIFO (last-in-first-out); FIFO (first-in-first-out) and average costing are all ways to value inventory.
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LIFO, FIFO and Average Costing
As you know, your inventory items are continually being sold and restocked. Since the associated costs are constantly changing, each company must select a cost flow assumption, which is the method available for moving the costs of a company's products from its inventory to its cost of goods sold.
FIFO means that the goods first added to inventory are assumed to be the first goods removed from inventory for sale. FIFO also means that the more recent costs of an item will remain in the Inventory account and will be reported on the balance sheet.
LIFO means the oldest cost of an item in inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.
Average Costing means that the cost of inventory is based on the average cost of good available for sale.
As a way of illustrating LIFO, FIFO and average cost flow assumptions, consider the following example:
- Say your company has four units of the same product in its inventory. The units were purchased at increasing costs in the following sequence: $20, $21, $23 and $24. If your company ships the oldest unit ($20), it will expense via the cost of goods sold: $20 under FIFO, $24 under LIFO, or $22 under the average method.
- If your company ships the most recently purchased unit ($24), the inventory will be reduced and the cost of goods sold will be increased by $20 under FIFO, $24 under LIFO, or the average of $22.
The cost used to reduce the inventory and to increase the cost of goods sold is based on an assumed cost flow regardless of which physical unit was actually shipped.
Why is Inventory Valuation Important?
An accurate valuation of your inventory is essential to your manufacturing operation business. Think of it this way: The reported amount of your operation’s inventory will affect:
- Cost of goods sold, gross profit and net income on your income statement
- The amount of current assets, working capital, total asset and owner’s equity on your balance sheet
The ending inventory of one accounting period automatically becomes the beginning inventory in the subsequent accounting period. Therefore, an incorrect inventory valuation affects your financial statements for several years.
Additional Considerations for Inventory Valuation
The GAAP guidelines discussed above don’t account for the entire picture of your inventory. Other measurements, such as overhead and “lean” accounting are just as important in valuing your operation.
Manufacturing overhead refers to all the indirect costs that are incurred in your manufacturing activity—costs that can’t be directly traced to the physical units in a manner that is economically feasible. Examples include depreciation of equipment and the wages for those who inspect your equipment.
Direct labor refers to the employees and temporary help who work directly on a manufacturer's products. It includes the cost of the wages and fringe benefits of the direct labor employees as well as the cost of the temporary help who work directly on the manufacturer's products. Direct labor is considered a cost tied to inventory.
Think of it as a chain reaction. Having more inventory on hand than is necessary to get the job done creates a risk that you will not use all the inventory that you have. This can affect the cash flow for your manufacturing operation and the valuation of your overall inventory. That’s where lean manufacturing comes into play. Lean manufacturing is a method for reducing the amount of waste occurring in the manufacturing process without losing productivity. While it is not a new concept, it’s one that is important to factor into the full valuation picture for your manufacturing inventory.
With this in mind, companies are moving toward blending lean manufacturing with a manufacturer’s standard financial statements.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.