Inventory Valuation Methods

For many companies, inventory represents a large portion of assets and, as such,
makes up an important part of the balance sheet. It is, therefore, crucial for those
who are analyzing stocks to understand how inventory is valued.

The accounting method that a company decides to use to determine the costs of inventory
can directly impact the balance sheet, income statement and statement of cash flow.
There are three inventory-costing methods that are widely used by both public and private companies:

• First-In, First-Out (FIFO) - This method assumes that the first unit making its way into inventory is the first sold. 

For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each,  and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (Cost of Good Sold) is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).

• Last-In, First-Out (LIFO) - This method assumes that the last unit making its way into inventory is sold first. 

The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.

• Average Cost - This method is quite straightforward; it takes the weighted average of all units available for sale 

During the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.

An important point in the examples above is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets.

Why Is Inventory Important? 
If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact same results. When prices are stable our bakery would be able to produce all of its loafs of bread at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.

Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.

If prices are rising, each of the accounting methods produce the following results:

• FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay. 

• LIFO isn't a good indicator of ending inventory value because the left over inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher. 

• Average cost produces results that fall somewhere between FIFO and LIFO. 

Note: if prices are decreasing then the complete opposite of the above is true.